Stock market

A stock market or equity market is a public (a loose network of economic transactions, not a
physical facility or discrete) entity for the trading of company stock (shares) and derivatives at an
agreed price; these are securities listed on a stock exchange as well as those only traded
privately.
The size of the world stock market was estimated at about $36.6 trillion at the start of October
2008.[1] The total world derivatives market has been estimated at about $791 trillion face or
nominal value,[2] 11 times the size of the entire world economy.[3] The value of the derivatives
market, because it is stated in terms of notional values, cannot be directly compared to a stock or
a fixed income security, which traditionally refers to an actual value. Moreover, the vast majority
of derivatives 'cancel' each other out (i.e., a derivative 'bet' on an event occurring is offset by a
comparable derivative 'bet' on the event not occurring). Many such relatively illiquid securities
are valued as marked to model, rather than an actual market price.
Market participants
A few decades ago, worldwide, buyers and sellers were individual investors, such as wealthy
businessmen, usually with long family histories to particular corporations. Over time, markets
have become more "institutionalized"; buyers and sellers are largely institutions (e.g., pension
funds, insurance companies, mutual funds, index funds, exchange-traded funds, hedge funds,
investor groups, banks and various other financial institutions).
The rise of the institutional investor has brought with it some improvements in market
operations. Thus, the government was responsible for "fixed" (and exorbitant) fees being
markedly reduced for the 'small' investor, but only after the large institutions had managed to
break the brokers' solid front on fees. (They then went to 'negotiated' fees, but only for large
institutions.[citation needed])
However, corporate governance (at least in the West) has been very much adversely affected by
the rise of (largely 'absentee') institutional 'owners
Importance of stock market
Function and purpose

The main trading room of the Tokyo Stock Exchange,where trading is currently completed
through computers.
The stock market is one of the most important sources for companies to raise money. This
allows businesses to be publicly traded, or raise additional financial capital for expansion by
selling shares of ownership of the company in a public market. The liquidity that an exchange
provides affords investors the ability to quickly and easily sell securities. This is an attractive
feature of investing in stocks, compared to other less liquid investments such as real estate.[citation
needed]

History has shown that the price of shares and other assets is an important part of the dynamics
of economic activity, and can influence or be an indicator of social mood. An economy where
the stock market is on the rise is considered to be an up-and-coming economy. In fact, the stock
market is often considered the primary indicator of a country's economic strength and
development.[citation needed]
Rising share prices, for instance, tend to be associated with increased business investment and
vice versa. Share prices also affect the wealth of households and their consumption. Therefore,
central banks tend to keep an eye on the control and behavior of the stock market and, in general,
on the smooth operation of financial system functions. Financial stability is the raison d'être of
central banks.[citation needed]
Exchanges also act as the clearinghouse for each transaction, meaning that they collect and
deliver the shares, and guarantee payment to the seller of a security. This eliminates the risk to an
individual buyer or seller that the counterparty could default on the transaction.[citation needed]
The smooth functioning of all these activities facilitates economic growth in that lower costs and
enterprise risks promote the production of goods and services as well as employment. In this way
the financial system contributes to increased prosperity.
Organized market for the sale and purchase of securities (see security) such as stocks and bonds.
Trading is done in various ways: it may occur on a continuous auction basis, it may involve
brokers buying from and selling to dealers in certain types of stock, or it may be conducted
through specialists in a particular stock.Organized marketplace in which stocks, Common Stock
Equivalents and bonds are traded by members of the exchange, acting both as agents (brokers)
and as principals (dealers or traders).
Stock market exchanges are a real or virtual location for the sale and purchase of private equities.
A way for private enterprises to raise investment funds.
The first stock market exchange in post-Soviet Russia was primarily trade in privatization
vouchers. As privatization proceeded apace, so did the volume of transactions on Russian
exchanges. Shares in certain Russian enterprises, particularly those of oil and gas companies,
were also increasingly offered on the market, but the stock market or markets in Russia have yet
to offer enterprises significant sources of either domestic or foreign investment funds.
stock exchange, organized market for the trading of stocks and bonds (see bond; stock). Such
markets were originally open to all, but at present only members of the owning association may
buy and sell directly. Members, or stock brokers, buy and sell for themselves or for others,
charging commissions for their services

Role and Significance of Stock Exchange

Most industrialized nations have a stock exchange at the center of their economies. The stock
exchange acts as the hub for buying and selling securities. The largest of the exchanges (based
on total market capitalization) is the New York Stock Exchange (NYSE).
1. History
○ According to French historian Fernand Braudel, "In 11th century Cairo, Islamic
and Jewish traders had already established every form of trade." However, other
historians attribute the first stock market to the French courratiers de change.
These men regulated the debts of agricultural communities on behalf of the banks.
Role
 ○ The most significant role of the stock exchange is to assist, regulate and control
the buying and selling of securities. The exchange also provides the physical
location and market in which investors can trade.
Significance
○ The exchange's function is significant to the securities market. By regulating
trading practices, it ensures that no single investor has an unfair advantage over
another.
Additional Importance
○ According to Stockexchangesecrets.com, "Stock exchanges perform an important
role in a national economy. They encourage investment by providing places for
buyers and sellers to trade securities. This investment, in turn, enables
corporations to obtain funds to expand their businesses."
Secondary Market
○ When a corporation issues new securities, it is done via the primary market. After
this initial public offering, shares are bought and sold through an exchange that
functions as a secondary market.

What is foreign investment?

Any investment flowing from one country into another is foreign investment.

A simple and commonly-used definition says financial investment by which a person or an entity
acquires a lasting interest in, and a degree of influence over, the management of a business enterprise in
a foreign country is foreign investment. Globally, various types of technical definitions –– including those
from IMF and OECD –– are used to define foreign investment.

How does the Indian government classify foreign investment?

The Indian government differentiates cross-border capital inflows into various categories like foreign
direct investment (FDI), foreign institutional investment (FII), non-resident Indian (NRI) and person of
Indian origin (PIO) investment. Inflow of investment from other countries is encouraged since it
complements domestic investments in capital-scarce economies of developing countries, India opened up
to investments from abroad gradually over the past two decades, especially since the landmark economic
liberalisation of 1991. Apart from helping in creating additional economic activity and generating
employment, foreign investment also facilitates flow of technology into the country and helps the industry
to become more competitive.

Why does the government differentiate between various forms of foreign investment?
 FDI is preferred over FII investments since it is considered to be the most beneficial form of foreign
investment for the economy as a whole. Direct investment targets a specific enterprise, with the aim of
increasing its capacity/productivity or changing its management control. Direct investment to create or
augment capacity ensures that the capital inflow translates into additional production. In the case of FII
investment that flows into the secondary market, the effect is to increase capital availability in general,
rather than availability of capital to a particular enterprise. Translating an FII inflow into additional
production depends on production decisions by someone other than the foreign investor — some local
investor has to draw upon the additional capital made available via FII inflows to augment production. In
the case of FDI that flows in for the purpose of acquiring an existing asset, no addition to production
capacity takes place as a direct result of the FDI inflow. Just like in the case of FII inflows, in this case too,
addition to production capacity does not result from the action of the foreign investor – the domestic seller
has to invest the proceeds of the sale in a manner that augments capacity or productivity for the foreign
capital inflow to boost domestic production. There is a widespread notion that FII inflows are hot money
— that it comes and goes, creating volatility in the stock market and exchange rates. While this might be
true of individual funds, cumulatively, FII inflows have only provided net inflows of capital.

FDI tends to be much more stable than FII inflows. Moreover, FDI brings not just capital but also better
management and governance practices and, often, technology transfer. The know-how thus transferred
along with FDI is often more crucial than the capital per se. No such benefit accrues in the case of FII
inflows, although the search by FIIs for credible investment options has tended to improve accounting and
governance practices among listed Indian companies.

According to the Prime Minister’s Economic Advisory Committee, net FDI inflows amounted to $8.5
billion in 2006-07 and is estimated to have gone up to $15.5 billion in 07-08. The panel feels FDI inflows
would increase to $19.7 billion during the current financial year. FDI up to 100% is allowed in sectors like
textiles or automobiles while the government has put in place foreign investment ceilings in the case of
sectors like telecom (74%). In some areas like gambling or lottery, no foreign investment is allowed.

According to the government’s definition, FIIs include asset management companies, pension funds,
mutual funds, investment trusts as nominee companies, incorporated/institutional portfolio managers or
their power of attorney holders, university funds, endowment foundations, charitable trusts and charitable
societies. FIIs are required to allocate their investment between equity and debt instruments in the ratio of
70:30. However, it is also possible for an FII to declare itself a 100% debt FII in which case it can make its
entire investment in debt instruments. The government allows greater freedom to FDI in various sectors
as compared to FII investments. However, there are peculiar cases like airlines where foreign investment,
including FII investment, is allowed to the extent of 49%, but FDI from foreign airlines is not allowed.

What are the restrictions that FIIs face in India?

FIIs can buy/sell securities on Indian stock exchanges, but they have to get registered with stock
market regulator Sebi. They can also invest in listed and unlisted securities outside stock exchanges if the
price at which stake is sold has been approved by RBI. No individual FII/sub-account can acquire more
than 10% of the paid up capital of an Indian company. All FIIs and their sub-accounts taken together
cannot acquire more than 24% of the paid up capital of an Indian Company, unless the Indian Company
raises the 24% ceiling to the sectoral cap or statutory ceiling as applicable by passing a board resolution
and a special resolution to that effect by its general body in terms of RBI press release of September 20,
2001 and FEMA Notification No.45 of the same date. In addition, the government also introduces new
regulations from time to time to ensure that FII investments are in order. For example, investment through
participatory notes (PNs) was curbed by Sebi recently.
Foreign Institutional Investor - FII

What Does Foreign Institutional Investor - FII Mean?

An investor or investment fund that is from or registered in a country outside of the one in which
it is currently investing. Institutional investors include hedge funds, insurance companies,
pension funds and mutual funds.

Investopedia explains Foreign Institutional Investor - FII

The term is used most commonly in India to refer to outside companies investing in the financial
markets of India. International institutional investors must register with the Securities and
Exchange Board of India to participate in the market. One of the major market regulations
pertaining to FIIs involves placing limits on FII ownership in Indian companies.

Foreign direct investment (FDI) or foreign investment refers to the net

inflows of investment to acquire a lasting management interest (10 percent or more of voting
stock) in an enterprise operating in an economy other than that of the investor.[1] It is the sum of
equity capital, reinvestment of earnings, other long-term capital, and short-term capital as shown
in the balance of payments. It usually involves participation in management, joint-venture,
transfer of technology and expertise. There are two types of FDI: inward foreign direct
investment and outward foreign direct investment, resulting in a net FDI inflow (positive or
negative) and "stock of foreign direct investment", which is the cumulative number for a given
period. Direct investment excludes investment through purchase of shares.[2] FDI is one example
of international factor movements.

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Swap (finance)
In finance, a swap is a derivative in which counterparties exchange certain benefits of one party's
financial instrument for those of the other party's financial instrument. The benefits in question
depend on the type of financial instruments involved. For example, in the case of a swap
involving two bonds, the benefits in question can be the periodic interest (or coupon) payments
associated with the bonds. Specifically, the two counterparties agree to exchange one stream of
cash flows against another stream. These streams are called the legs of the swap. The swap
agreement defines the dates when the cash flows are to be paid and the way they are calculated.[1]
Usually at the time when the contract is initiated at least one of these series of cash flows is
determined by a random or uncertain variable such as an interest rate, foreign exchange rate,
equity price or commodity price.[1]
The cash flows are calculated over a notional principal amount, which is usually not exchanged
between counterparties. Consequently, swaps can be in cash or collateral.
Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in
the expected direction of underlying prices.
Swaps were first introduced to the public in 1981 when IBM and the World Bank entered into a
swap agreement.[2] Today, swaps are among the most heavily traded financial contracts in the
world: the total amount of interest rates and currency swaps outstanding is more thаn $426.7
trillion in 2009, according to International Swaps and Derivatives Association (ISDA).
Swap market
Most swaps are traded over-the-counter (OTC), "tailor-made" for the counterparties. Some types
of swaps are also exchanged on futures markets such as the Chicago Mercantile Exchange
Holdings Inc., the largest U.S. futures market, the Chicago Board Options Exchange,
IntercontinentalExchange and Frankfurt-based Eurex AG.
Depending on the type of swap whether its interest swap,
credit default, or the total return swap the definition
varies, the basis idea being acquiring some thing which
the
organization has no privilege of, for eg: banks generally
are not allowed to invest in fancy instrument like
variable
rated or commonly floating rated securities so they
approach a middle men to sell their fixed in return of a
floating rated securities.
Depending on the type of swap whether its interest swap,
credit default, or the total return swap the definition
varies, the basis idea being acquiring some thing which
the
organization has no privilege of, for eg: banks generally
are not allowed to invest in fancy instrument like
variable
rated or commonly floating rated securities so they
approach a middle men to sell their fixed in return of a
floating rated securities.
Depending on the type of swap whether its interest swap,
credit default, or the total return swap the definition
varies, the basis idea being acquiring some thing which
the
organization has no privilege of, for eg: banks generally
are not allowed to invest in fancy instrument like
variable
rated or commonly floating rated securities so they
approach a middle men to sell their fixed in return of a
floating rated securities.

Derivative (finance)
In finance, a derivative is a financial instrument whose value depends on other, more basic,
underlying variables[1] Such variables can be the price of another financial instrument (the
underlying asset[2]), interest rates, volatilities, indices, etc.contract whose payoff depends on the
behavior of some benchmark, which is known as the "underlying". The most common
derivatives are futures, options, and swaps.
Among the oldest of these are rice futures, which have been traded on the Dojima Rice Exchange
since the eighteenth century.[3]
Derivatives are usually broadly categorized by:
• the relationship between the underlying asset and the derivative (e.g., forward, option,
swap);
• the type of underlying asset (e.g., equity derivatives, foreign exchange derivatives,
interest rate derivatives, commodity derivatives or credit derivatives);
• the market in which they trade (e.g., exchange-traded or over-the-counter); and
• their pay-off profile.
Derivatives can be used for speculating purposes ("bets") or to hedge ("insurance"). For example,
a speculator may sell deep in-the-money naked calls on a stock, expecting the stock price to
plummet, but exposing himself to potentially unlimited losses. Very commonly, companies buy
currency forwards in order to limit losses due to fluctuations in the exchange rate of two
currencies.

Hedging
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Derivatives allow risk related to the price of the underlying asset to be transferred from one party
to another. For example, a wheat farmer and a miller could sign a futures contract to exchange a
specified amount of cash for a specified amount of wheat in the future. Both parties have reduced
a future risk: for the wheat farmer, the uncertainty of the price, and for the miller, the availability
of wheat. However, there is still the risk that no wheat will be available because of events
unspecified by the contract, such as the weather, or that one party will renege on the contract.
Although a third party, called a clearing house, insures a futures contract, not all derivatives are
insured against counter-party risk.
From another perspective, the farmer and the miller both reduce a risk and acquire a risk when
they sign the futures contract: the farmer reduces the risk that the price of wheat will fall below
the price specified in the contract and acquires the risk that the price of wheat will rise above the
price specified in the contract (thereby losing additional income that he could have earned). The
miller, on the other hand, acquires the risk that the price of wheat will fall below the price
specified in the contract (thereby paying more in the future than he otherwise would have) and
reduces the risk that the price of wheat will rise above the price specified in the contract. In this
sense, one party is the insurer (risk taker) for one type of risk, and the counter-party is the insurer
(risk taker) for another type of risk.
Hedging also occurs when an individual or institution buys an asset (such as a commodity, a
bond that has coupon payments, a stock that pays dividends, and so on) and sells it using a
futures contract. The individual or institution has access to the asset for a specified amount of
time, and can then sell it in the future at a specified price according to the futures contract. Of
course, this allows the individual or institution the benefit of holding the asset, while reducing
the risk that the future selling price will deviate unexpectedly from the market's current
assessment of the future value of the asset.

Derivatives traders at the Chicago Board of Trade.

Derivatives can serve legitimate business purposes. For example, a corporation borrows a large
sum of money at a specific interest rate.[4] The rate of interest on the loan resets every six months.
The corporation is concerned that the rate of interest may be much higher in six months. The
corporation could buy a forward rate agreement (FRA), which is a contract to pay a fixed rate of
interest six months after purchases on a notional amount of money.[5] If the interest rate after six
months is above the contract rate, the seller will pay the difference to the corporation, or FRA
buyer. If the rate is lower, the corporation will pay the difference to the seller. The purchase of
the FRA serves to reduce the uncertainty concerning the rate increase and stabilize earnings.
[edit] Speculation and arbitrage
Derivatives can be used to acquire risk, rather than to insure or hedge against risk. Thus, some
individuals and institutions will enter into a derivative contract to speculate on the value of the
underlying asset, betting that the party seeking insurance will be wrong about the future value of
the underlying asset. Speculators look to buy an asset in the future at a low price according to a
derivative contract when the future market price is high, or to sell an asset in the future at a high
price according to a derivative contract when the future market price is low.
Individuals and institutions may also look for arbitrage opportunities, as when the current buying
price of an asset falls below the price specified in a futures contract to sell the asset.
Speculative trading in derivatives gained a great deal of notoriety in 1995 when Nick Leeson, a
trader at Barings Bank, made poor and unauthorized investments in futures contracts. Through a
combination of poor judgment, lack of oversight by the bank's management and regulators, and
unfortunate events like the Kobe earthquake, Leeson incurred a US$1.3 billion loss that
bankrupted the centuries-old institution.[6]
[edit] Types of derivatives
[edit] OTC and exchange-traded
In broad terms, there are two groups of derivative contracts, which are distinguished by the way
they are traded in the market:
• Over-the-counter (OTC) derivatives are contracts that are traded (and privately
negotiated) directly between two parties, without going through an exchange or other
intermediary. Products such as swaps, forward rate agreements, and exotic options are
almost always traded in this way. The OTC derivative market is the largest market for
derivatives, and is largely unregulated with respect to disclosure of information between
the parties, since the OTC market is made up of banks and other highly sophisticated
parties, such as hedge funds. Reporting of OTC amounts are difficult because trades can
occur in private, without activity being visible on any exchange. According to the Bank
for International Settlements, the total outstanding notional amount is US$684 trillion (as
of June 2008).[7] Of this total notional amount, 67% are interest rate contracts, 8% are
credit default swaps (CDS), 9% are foreign exchange contracts, 2% are commodity
contracts, 1% are equity contracts, and 12% are other. Because OTC derivatives are not
traded on an exchange, there is no central counter-party. Therefore, they are subject to
counter-party risk, like an ordinary contract, since each counter-party relies on the other
to perform.
• Exchange-traded derivative contracts (ETD) are those derivatives instruments that are
traded via specialized derivatives exchanges or other exchanges. A derivatives exchange
is a market where individuals trade standardized contracts that have been defined by the
exchange.[8] A derivatives exchange acts as an intermediary to all related transactions, and
takes Initial margin from both sides of the trade to act as a guarantee. The world's
largest[9] derivatives exchanges (by number of transactions) are the Korea Exchange
(which lists KOSPI Index Futures & Options), Eurex (which lists a wide range of
European products such as interest rate & index products), and CME Group (made up of
the 2007 merger of the Chicago Mercantile Exchange and the Chicago Board of Trade
and the 2008 acquisition of the New York Mercantile Exchange). According to BIS, the
combined turnover in the world's derivatives exchanges totaled USD 344 trillion during
Q4 2005. Some types of derivative instruments also may trade on traditional exchanges.
For instance, hybrid instruments such as convertible bonds and/or convertible preferred
may be listed on stock or bond exchanges. Also, warrants (or "rights") may be listed on
equity exchanges. Performance Rights, Cash xPRTs and various other instruments that
essentially consist of a complex set of options bundled into a simple package are
routinely listed on equity exchanges. Like other derivatives, these publicly traded
derivatives provide investors access to risk/reward and volatility characteristics that,
while related to an underlying commodity, nonetheless are distinctive.
[edit] Common derivative contract types
There are three major classes of derivatives:
 1. Futures/Forwards are contracts to buy or sell an asset on or before a future date at a price
specified today. A futures contract differs from a forward contract in that the futures
contract is a standardized contract written by a clearing house that operates an exchange
where the contract can be bought and sold, whereas a forward contract is a non-
standardized contract written by the parties themselves.
2. Options are contracts that give the owner the right, but not the obligation, to buy (in the
case of a call option) or sell (in the case of a put option) an asset. The price at which the
sale takes place is known as the strike price, and is specified at the time the parties enter
into the option. The option contract also specifies a maturity date. In the case of a
European option, the owner has the right to require the sale to take place on (but not
before) the maturity date; in the case of an American option, the owner can require the
sale to take place at any time up to the maturity date. If the owner of the contract
exercises this right, the counter-party has the oblig
Govt.Securities

3.
Government securities(G-secs) are sovereign securities which are issued by the
Reserve Bank of India on behalf of Government of India,in lieu of the Central
Government's market borrowing programme.
4. The term Government Securities includes:
Central Government Securities.
State Government Securities
Treasury bills
5. The Central Government borrows funds to finance its 'fiscal deficit'.The market
borrowing of the Central Government is raised through the issue of dated securities
and 364 days treasury bills either by auction or by floatation of loans.
6. In addition to the above, treasury bills of 91 days are issued for managing the
temporary cash mismatches of the Government. These do not form part of the
borrowing programme of the Central Government.

7.government securities
8.
9. Definition
10. Securities issued by a government to raise the funds necessary to pay for its expenses.
11.
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12.Government bond
13. A bond is a debt investment in which an investor loans a certain amount of money, for a
certain amount of time, with a certain interest rate, to a Government .
A government bond is a bond issued by a national government denominated in the
country's own currency. Countries within the EuroZone will issue Bonds for a currency
shared by other nation states, formerly the countries of Germany, Portugal, Ireland,
Spain, Greece, Italy, which are not countries but Eurozone States. Bonds issued by
national governments in foreign currencies are normally referred to as sovereign bonds.
 The first ever government bond was issued by the English government in 1693 to raise
money to fund a war against France. It was in the form of a tontine. Bankers issue bonds
to lend money at interst to governments in times of war. War is a key investment strategy
to leverage government borrowing.

Dow Theory
Dow Theory on stock price movement is a form of technical analysis that includes some aspects
of sector rotation. The theory was derived from 255 Wall Street Journal editorials written by
Charles H. Dow (1851–1902), journalist, founder and first editor of the Wall Street Journal and
co-founder of Dow Jones and Company. Following Dow's death, William Peter Hamilton,
Robert Rhea and E. George Schaefer organized and collectively represented "Dow Theory,"
based on Dow's editorials. Dow himself never used the term "Dow Theory," nor presented it as a
trading system.
The six basic tenets of Dow Theory as summarized by Hamilton, Rhea, and Schaefer are
described below.
Six basic tenets of Dow Theory
1. The market has three movements
(1) The "main movement", primary movement or major trend may last from less than a
year to several years. It can be bullish or bearish. (2) The "medium swing", secondary
reaction or intermediate reaction may last from ten days to three months and generally
retraces from 33% to 66% of the primary price change since the previous medium swing
or start of the main movement. (3) The "short swing" or minor movement varies with
opinion from hours to a month or more. The three movements may be simultaneous, for
instance, a daily minor movement in a bearish secondary reaction in a bullish primary
movement.
2. Market trends have three phases
Dow Theory asserts that major market trends are composed of three phases: an
accumulation phase, a public participation phase, and a distribution phase. The
accumulation phase (phase 1) is a period when investors "in the know" are actively
buying (selling) stock against the general opinion of the market. During this phase, the
stock price does not change much because these investors are in the minority absorbing
(releasing) stock that the market at large is supplying (demanding). Eventually, the
market catches on to these astute investors and a rapid price change occurs (phase 2).
This occurs when trend followers and other technically oriented investors participate.
This phase continues until rampant speculation occurs. At this point, the astute investors
begin to distribute their holdings to the market (phase 3).
3. The stock market discounts all news
Stock prices quickly incorporate new information as soon as it becomes available. Once
news is released, stock prices will change to reflect this new information. On this point,
Dow Theory agrees with one of the premises of the efficient market hypothesis.
4. Stock market averages must confirm each other
 In Dow's time, the US was a growing industrial power. The US had population centers
but factories were scattered throughout the country. Factories had to ship their goods to
market, usually by rail. Dow's first stock averages were an index of industrial
(manufacturing) companies and rail companies. To Dow, a bull market in industrials
could not occur unless the railway average rallied as well, usually first. According to this
logic, if manufacturers' profits are rising, it follows that they are producing more. If they
produce more, then they have to ship more goods to consumers. Hence, if an investor is
looking for signs of health in manufacturers, he or she should look at the performance of
the companies that ship the output of them to market, the railroads. The two averages
should be moving in the same direction. When the performance of the averages diverge,
it is a warning that change is in the air.
Both Barron's Magazine and the Wall Street Journal still publish the daily performance of
the Dow Jones Transportation Index in chart form. The index contains major railroads,
shipping companies, and air freight carriers in the US.
5. Trends are confirmed by volume
Dow believed that volume confirmed price trends. When prices move on low volume,
there could be many different explanations why. An overly aggressive seller could be
present for example. But when price movements are accompanied by high volume, Dow
believed this represented the "true" market view. If many participants are active in a
particular security, and the price moves significantly in one direction, Dow maintained
that this was the direction in which the market anticipated continued movement. To him,
it was a signal that a trend is developing.
6. Trends exist until definitive signals prove that they have ended
Dow believed that trends existed despite "market noise". Markets might temporarily
move in the direction opposite to the trend, but they will soon resume the prior move. The
trend should be given the benefit of the doubt during these reversals. Determining
whether a reversal is the start of a new trend or a temporary movement in the current
trend is not easy. Dow Theorists often disagree in this determination. Technical analysis
tools attempt to clarify this but they can be interpreted differently by different investors.

Technical analysis
Technical analysis is a financial term used to denote a security analysis
discipline for forecasting the direction of prices through the study of past
market data, primarily price and volume.[1] Behavioral economics and
quantitative analysis incorporate technical analysis, which being an aspect of
active management stands in contradiction to much of modern portfolio
theory. The efficacy of technical analysis is disputed by efficient-market
hypothesis since stock market prices are essentially unpredictable

Fundamental analysis
Fundamental analysis of a business involves analyzing its financial statements and health, its
management and competitive advantages, and its competitors and markets. When applied to
futures and forex, it focuses on the overall state of the economy, interest rates, production,
earnings, and management. When analyzing a stock, futures contract, or currency using
fundamental analysis there are two basic approaches one can use; bottom up analysis and top
down analysis.[1] The term is used to distinguish such analysis from other types of investment
analysis, such as quantitative analysis and technical analysis.
Fundamental analysis is performed on historical and present data, but with the goal of making
financial forecasts. There are several possible objectives:
• to conduct a company stock valuation and predict its probable price evolution,
• to make a projection on its business performance,
• to evaluate its management and make internal business decisions,
• to calculate its credit risk.
Two analytical models
When the objective of the analysis is to determine what stock to buy and at what price, there are
two basic methodologies
1. Fundamental analysis maintains that markets may misprice a security in the short run but
that the "correct" price will eventually be reached. Profits can be made by trading the
mispriced security and then waiting for the market to recognize its "mistake" and reprice
the security.
2. Technical analysis maintains that all information is reflected already in the stock price.
Trends 'are your friend' and sentiment changes predate and predict trend changes.
Investors' emotional responses to price movements lead to recognizable price chart
patterns. Technical analysis does not care what the 'value' of a stock is. Their price
predictions are only extrapolations from historical price patterns.
Investors can use any or all of these different but somewhat complementary methods for stock
picking. For example many fundamental investors use technicals for deciding entry and exit
points. Many technical investors use fundamentals to limit their universe of possible stock to
'good' companies.
The choice of stock analysis is determined by the investor's belief in the different paradigms for
"how the stock market works". See the discussions at efficient-market hypothesis, random walk
hypothesis, capital asset pricing model, Fed model Theory of Equity Valuation, Market-based
valuation, and Behavioral finance.
Fundamental analysis includes:
1. Economic analysis
2. Industry analysis
3. Company analysis
On the basis of these three analyses the intrinsic value of the shares are determined. This is
considered as the true value of the share. If the intrinsic value is higher than the market price it is
recommended to buy the share . If it is equal to market price hold the share and if it is less than
the market price sell the shares.
In finance a share is a unit of account for various financial instruments including stocks, mutual funds,
limited partnerships, and REIT's. In British English, the usage of the word share alone to refer solely to
stocks is so common that it almost replaces the word stock itself.

In simple Words, a share or stock is a Sponsored

document issued by a company, which Links
entitles its holder to be one of the owners
of the company. A share is issued by a
company or can be purchased from the
stock market.
By owning a share you can earn a portion
and selling shares you get capital gain. So, your return is the dividend plus the capital gain. However,
you also run a risk of making a capital loss if you have sold the share at a price below your buying price.
A company's stock price reflects what investors think about the stock, not necessarily what the
company is "worth." For example, companies that are growing quickly often trade at a higher price than
the company might currently be "worth." Stock prices are also affected by all forms of company and
market news. Publicly traded companies are required to report quarterly on their financial status and
earnings. Market forces and general investor opinions can also affect share price.

Stock
The capital stock (or just stock) of a business entity represents the original capital paid into or
invested in the business by its founders. It serves as a security for the creditors of a business
since it cannot be withdrawn to the detriment of the creditors. Stock is distinct from the property
and the assets of a business which may fluctuate in quantity and value.
Shares
The stock of a business is divided into shares, the total of which must be stated at the time of
business formation. Given the total amount of money invested in the business, a share has a
certain declared face value, commonly known as the par value of a share. The par value is the de
minimis (minimum) amount of money that a business may issue and sell shares for in many
jurisdictions and it is the value represented as capital in the accounting of the business. In other
jurisdictions, however, shares may not have an associated par value at all. Such stock is often
called non-par stock. Shares represent a fraction of ownership in a business. A business may
declare different types (classes) of shares, each having distinctive ownership rules, privileges, or
share values.
Ownership of shares is documented by issuance of a stock certificate. A stock certificate is a
legal document that specifies the amount of shares owned by the shareholder, and other specifics
of the shares, such as the par value, if any, or the class of the shares.

Debenture
In law, a debenture is a document that either creates a debt or acknowledges it. In corporate
finance, the term is used for a medium- to long-term debt instrument used by large companies to
borrow money. In some countries the term is used interchangeably with bond, loan stock or
note. A debenture is thus like a certificate of loan or a loan bond evidencing the fact that the
company is liable to pay a specified amount with interest and although the money raised by the
debentures becomes a part of the company's capital structure, it does not become share capital..[1]
Debentures are generally freely transferable by the debenture holder. Debenture holders have no
rights to vote in the company's general meetings of shareholders, but they may have separate
meetings or votes e.g. on changes to the rights attached to the debentures. The interest paid to
them is a charge against profit in the company's financial statements.

Bond (finance)
n finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and,
depending on the terms of the bond, is obliged to pay interest (the coupon) to use and/or to repay
the principal at a later date, termed maturity. A bond is a formal contract to repay borrowed
money with interest at fixed intervals.[1]
Thus a bond is like a loan: the issuer is the borrower (debtor), the holder is the lender (creditor),
and the coupon is the interest. Bonds provide the borrower with external funds to finance long-
term investments, or, in the case of government bonds, to finance current expenditure.
Certificates of deposit (CDs) or commercial paper are considered to be money market
instruments and not bonds.
Bonds and stocks are both securities, but the major difference between the two is that (capital)
stockholders have an equity stake in the company (i.e., they are owners), whereas bondholders
have a creditor stake in the company (i.e., they are lenders). Another difference is that bonds
usually have a defined term, or maturity, after which the bond is redeemed, whereas stocks may
be outstanding indefinitely. An exception is a consol bond, which is a perpetuity (i.e., bond with
no maturity).

Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and,
depending on the terms of the bond, is obliged to pay interest (the coupon) to use and/or to repay
the principal at a later date, termed maturity. A bond is a formal contract to repay borrowed
money with interest at fixed intervals.[1]
Thus a bond is like a loan: the issuer is the borrower (debtor), the holder is the lender (creditor),
and the coupon is the interest. Bonds provide the borrower with external funds to finance long-
term investments, or, in the case of government bonds, to finance current expenditure.
Certificates of deposit (CDs) or commercial paper are considered to be money market
instruments and not bonds.
Bonds and stocks are both securities, but the major difference between the two is that (capital)
stockholders have an equity stake in the company (i.e., they are owners), whereas bondholders
have a creditor stake in the company (i.e., they are lenders). Another difference is that bonds
usually have a defined term, or maturity, after which the bond is redeemed, whereas stocks may
be outstanding indefinitely. An exception is a consol bond, which is a perpetuity (i.e., bond with
no maturity).
Issuing bonds
Bonds are issued by public authorities, credit institutions, companies and supranational
institutions in the primary markets. The most common process of issuing bonds is through
underwriting. In underwriting, one or more securities firms or banks, forming a syndicate, buy an
entire issue of bonds from an issuer and re-sell them to investors. The security firm takes the risk
of being unable to sell on the issue to end investors. Primary issuance is arranged by
bookrunners who arrange the bond issue, have the direct contact with investors and act as
advisors to the bond issuer in terms of timing and price of the bond issue. The bookrunners'
willingness to underwrite must be discussed prior to opening books on a bond issue as there may
be limited appetite to do so.
In the case of government bonds, these are usually issued by auctions, called a public sale, where
both members of the public and banks may bid for bond. Since the coupon is fixed, but the price
is not, the percent return is a function both of the price paid as well as the coupon.[2] However,
because the cost of issuance for a publicly auctioned bond can be cost prohibitive for a smaller
loan, it is also common for smaller bonds to avoid the underwriting and auction process through
the use of a private placement bond. In the case of a private placement bond, the bond is held by
the lender and does not enter the large bond market.[3]
[edit] Features of bonds
The most important features of a bond are:
• nominal, principal or face amount — the amount on which the issuer pays interest, and
which, most commonly, has to be repaid at the end of the term. Some structured bonds
can have a redemption amount which is different from the face amount and can be linked
to performance of particular assets such as a stock or commodity index, foreign exchange
rate or a fund. This can result in an investor receiving less or more than his original
investment at maturity.
• issue price — the price at which investors buy the bonds when they are first issued,
which will typically be approximately equal to the nominal amount. The net proceeds that
the issuer receives are thus the issue price, less issuance fees.
• maturity date — the date on which the issuer has to repay the nominal amount. As long as
all payments have been made, the issuer has no more obligation to the bond holders after
the maturity date. The length of time until the maturity date is often referred to as the
term or tenor or maturity of a bond. The maturity can be any length of time, although
debt securities with a term of less than one year are generally designated money market
instruments rather than bonds. Most bonds have a term of up to thirty years. Some bonds
have been issued with maturities of up to one hundred years, and some even do not
mature at all. In the market for U.S. Treasury securities, there are three groups of bond
maturities:
○ short term (bills): maturities between one to five year; (instruments with
maturities less than one year are called Money Market Instruments)
○ medium term (notes): maturities between six to twelve years;
○ long term (bonds): maturities greater than twelve years.
• coupon — the interest rate that the issuer pays to the bond holders. Usually this rate is
fixed throughout the life of the bond. It can also vary with a money market index, such as
LIBOR, or it can be even more exotic. The name coupon originates from the fact that in
the past, physical bonds were issued which had coupons attached to them. On coupon
dates the bond holder would give the coupon to a bank in exchange for the interest
payment.
Bond issued by the Dutch East India Company in 1623
• The "quality" of the issue refers to the probability that the bondholders will receive the
amounts promised at the due dates. This will depend on a wide range of factors.
○ Indentures and Covenants — An indenture is a formal debt agreement that
establishes the terms of a bond issue, while covenants are the clauses of such an
agreement. Covenants specify the rights of bondholders and the duties of issuers,
such as actions that the issuer is obligated to perform or is prohibited from
performing. In the U.S., federal and state securities and commercial laws apply to
the enforcement of these agreements, which are construed by courts as contracts
between issuers and bondholders. The terms may be changed only with great
difficulty while the bonds are outstanding, with amendments to the governing
document generally requiring approval by a majority (or super-majority) vote of
the bondholders.
○ High yield bonds are bonds that are rated below investment grade by the credit
rating agencies. As these bonds are more risky than investment grade bonds,
investors expect to earn a higher yield. These bonds are also called junk bonds.
• coupon dates — the dates on which the issuer pays the coupon to the bond holders. In the
U.S. and also in the U.K. and Europe, most bonds are semi-annual, which means that
they pay a coupon every six months.
• Optionality: Occasionally a bond may contain an embedded option; that is, it grants
option-like features to the holder or the issuer:
○ Callability — Some bonds give the issuer the right to repay the bond before the
maturity date on the call dates; see call option. These bonds are referred to as
callable bonds. Most callable bonds allow the issuer to repay the bond at par.
With some bonds, the issuer has to pay a premium, the so called call premium.
This is mainly the case for high-yield bonds. These have very strict covenants,
restricting the issuer in its operations. To be free from these covenants, the issuer
can repay the bonds early, but only at a high cost.
○ Putability — Some bonds give the holder the right to force the issuer to repay the
bond before the maturity date on the put dates; see put option. (Note: "Putable"
denotes an embedded put option; "Puttable" denotes that it may be put.)
○ call dates and put dates—the dates on which callable and putable bonds can be
redeemed early. There are four main categories.
  A Bermudan callable has several call dates, usually coinciding with
coupon dates.
 A European callable has only one call date. This is a special case of a
Bermudan callable.
 An American callable can be called at any time until the maturity date.
 A death put is an optional redemption feature on a debt instrument
allowing the beneficiary of the estate of the deceased to put (sell) the bond
(back to the issuer) in the event of the beneficiary's death or legal
incapacitation. Also known as a "survivor's option".
• sinking fund provision of the corporate bond indenture requires a certain portion of the
issue to be retired periodically. The entire bond issue can be liquidated by the maturity
date. If that is not the case, then the remainder is called balloon maturity. Issuers may
either pay to trustees, which in turn call randomly selected bonds in the issue, or,
alternatively, purchase bonds in open market, then return them to trustees.
• convertible bond lets a bondholder exchange a bond to a number of shares of the issuer's
common stock.
• exchangeable bond allows for exchange to shares of a corporation other than the issuer.
[edit] Types of Bond

Bond certificate for the state of South Carolina issued in 1873 under the state's Consolidation
Act.
The following descriptions are not mutually exclusive, and more than one of them may apply to
a particular bond.
• Fixed rate bonds have a coupon that remains constant throughout the life of the bond.
• Floating rate notes (FRNs) have a variable coupon that is linked to a reference rate of
interest, such as LIBOR or Euribor. For example the coupon may be defined as three
month USD LIBOR + 0.20%. The coupon rate is recalculated periodically, typically
every one or three months.
• Zero-coupon bonds pay no regular interest. They are issued at a substantial discount to
par value, so that the interest is effectively rolled up to maturity (and usually taxed as
such). The bondholder receives the full principal amount on the redemption date. An
example of zero coupon bonds is Series E savings bonds issued by the U.S. government.
Zero-coupon bonds may be created from fixed rate bonds by a financial institution
 separating ("stripping off") the coupons from the principal. In other words, the separated
coupons and the final principal payment of the bond may be traded separately. See IO
(Interest Only) and PO (Principal Only).
• Inflation linked bonds, in which the principal amount and the interest payments are
indexed to inflation. The interest rate is normally lower than for fixed rate bonds with a
comparable maturity (this position briefly reversed itself for short-term UK bonds in
December 2008). However, as the principal amount grows, the payments increase with
inflation. The United Kingdom was the first sovereign issuer to issue inflation linked
Gilts in the 1980s. Treasury Inflation-Protected Securities (TIPS) and I-bonds are
examples of inflation linked bonds issued by the U.S. government.

Receipt for temporary bonds for the state of Kansas issued in 1922
• Other indexed bonds, for example equity-linked notes and bonds indexed on a business
indicator (income, added value) or on a country's GDP.
• Asset-backed securities are bonds whose interest and principal payments are backed by
underlying cash flows from other assets. Examples of asset-backed securities are
mortgage-backed securities (MBS's), collateralized mortgage obligations (CMOs) and
collateralized debt obligations (CDOs).
• Subordinated bonds are those that have a lower priority than other bonds of the issuer in
case of liquidation. In case of bankruptcy, there is a hierarchy of creditors. First the
liquidator is paid, then government taxes, etc. The first bond holders in line to be paid are
those holding what is called senior bonds. After they have been paid, the subordinated
bond holders are paid. As a result, the risk is higher. Therefore, subordinated bonds
usually have a lower credit rating than senior bonds. The main examples of subordinated
bonds can be found in bonds issued by banks, and asset-backed securities. The latter are
 often issued in tranches. The senior tranches get paid back first, the subordinated tranches
later.
• Perpetual bonds are also often called perpetuities or 'Perps'. They have no maturity date.
The most famous of these are the UK Consols, which are also known as Treasury
Annuities or Undated Treasuries. Some of these were issued back in 1888 and still trade
today, although the amounts are now insignificant. Some ultra-long-term bonds
(sometimes a bond can last centuries: West Shore Railroad issued a bond which matures
in 2361 (i.e. 24th century) are virtually perpetuities from a financial point of view, with
the current value of principal near zero.
• Bearer bond is an official certificate issued without a named holder. In other words, the
person who has the paper certificate can claim the value of the bond. Often they are
registered by a number to prevent counterfeiting, but may be traded like cash. Bearer
bonds are very risky because they can be lost or stolen. Especially after federal income
tax began in the United States, bearer bonds were seen as an opportunity to conceal
income or assets.[4] U.S. corporations stopped issuing bearer bonds in the 1960s, the U.S.
Treasury stopped in 1982, and state and local tax-exempt bearer bonds were prohibited in
1983.[5]
• Registered bond is a bond whose ownership (and any subsequent purchaser) is recorded
by the issuer, or by a transfer agent. It is the alternative to a Bearer bond. Interest
payments, and the principal upon maturity, are sent to the registered owner.
• Treasury bond, also called government bond, is issued by the Federal government and is
not exposed to default risk. It is characterized as the safest bond, with the lowest interest
rate. A treasury bond is backed by the “full faith and credit” of the federal government.
For that reason, this type of bond is often referred to as risk-free.

Pacific Railroad Bond issued by City and County of San Francisco, CA. May 1, 1865
Municipal bond is a bond issued by a state, U.S. Territory, city, local government, or
their agencies. Interest income received by holders of municipal bonds is often exempt
from the federal income tax and from the income tax of the state in which they are issued,
although municipal bonds issued for certain purposes may not be tax exempt.
• Build America Bonds (BABs) is a new form of municipal bond authorized by the
American Recovery and Reinvestment Act of 2009. Unlike traditional municipal bonds,
which are usually tax exempt, interest received on BABs is subject to federal taxation.
However, as with municipal bonds, the bond is tax-exempt within the state it is issued.
 Generally, BABs offer significantly higher yields (over 7 percent) than standard
municipal bonds.[6]
• Book-entry bond is a bond that does not have a paper certificate. As physically
processing paper bonds and interest coupons became more expensive, issuers (and banks
that used to collect coupon interest for depositors) have tried to discourage their use.
Some book-entry bond issues do not offer the option of a paper certificate, even to
investors who prefer them.[7]
• Lottery bond is a bond issued by a state, usually a European state. Interest is paid like a
traditional fixed rate bond, but the issuer will redeem randomly selected individual bonds
within the issue according to a schedule. Some of these redemptions will be for a higher
value than the face value of the bond.
• War bond is a bond issued by a country to fund a war.
• Serial bond is a bond that matures in installments over a period of time. In effect, a
$100,000, 5-year serial bond would mature in a $20,000 annuity over a 5-year interval.
• Revenue bond is a special type of municipal bond distinguished by its guarantee of
repayment solely from revenues generated by a specified revenue-generating entity
associated with the purpose of the bonds. Revenue bonds are typically "non-recourse,"
meaning that in the event of default, the bond holder has no recourse to other
governmental assets or revenues.
• Climate bond is a bond issued by a government or corporate entity in order to raise
finance for climate change mitigation or adaptation related projects or programs.

Bonds
You're the lender
Just as consumers borrow money for such things as a home or a college education, corporations
and governments borrow money to finance the things they require. Corporations and
governments need money to build or expand their operation, pay for operational expenses and
other costs associated with running an organization. Instead of going to a single lending
institution for the money, they have the option of borrowing money from many investors in the
form of a bond.
When you invest in a bond, you are lending money to the bond issuer. Bonds are often
referred to as income investments because, in return for the use of your money, the bond's issuer
agrees to pay a certain rate of interest at regular intervals for a set period until the bond matures
or the principal is otherwise repaid.
Features
• Set Maturity Dates — bonds have set maturity dates that can range from one to 30 years
— short-term bonds (mature in three years or less), intermediate bonds (mature in three
to ten years) and long-term bonds (mature in ten years or more)
• Interest Payments — bonds typically offer some form of interest payment; however,
this depends on their structure: "Fixed Rate Bonds" provide fixed interest payments on a
regular schedule for the life of the bond; "Floating Rate Bonds" have variable interest
rates that are periodically adjusted; and, "Zero Coupon Bonds" do not pay periodic
 interest at all, but offer an advantage in that they are can be bought at a discounted price
of the face value and can be redeemed at the face value at maturity
• Principal Investment Repayment — bond issuers are obligated to repay the full
principal amount of a bond in a lump sum when the bond reaches maturity
• Credit Ratings — You can evaluate the "default risk" (the risk that the issuers won't be
able to make interest or principal payments) of a bond by checking the rating it has been
given by a bond rating agency such as Moody's Investors Service or Standard and Poor's
• Callable Bonds — If the bond has a "call feature", the issuer is allowed to redeem the
bond before its maturity date, repay the loan and thus, stop paying interest on it
• Minimum Investment — Bonds are usually issued in $1,000 or $5,000 denominations
Benefits
• Bonds can be a reliable source of current income depending on the structure of the
bond you buy
• Bonds provide a certain element of liquidity, as the bond market is large and active
• If you sell a bond before it matures, you may receive more or less than your principal
investment because bond values fluctuate
• Generally, interest income from federal government bonds is exempt from taxation at
the state and local level, and the interest income from municipal bonds is usually not
subject to federal tax
• In the spectrum of the investment options, investment grade bonds are a relatively low-
risk investment
Types of Bonds
• Corporate bonds — represent money borrowed by a corporation or institution
• Municipal Bonds — are issued by states, counties, cities and local government authorities
• U.S. Government Securities — are issued to finance operations of the federal government
and are backed by the full faith and credit of the government

Bond valuation
Bond valuation is the determination of the fair price of a bond. As with any security or capital
investment, the theoretical fair value of a bond is the present value of the stream of cash flows it
is expected to generate. Hence, the value of a bond is obtained by discounting the bond's
expected cash flows to the present using an appropriate discount rate. In practice, this discount
rate is often determined by reference to similar instruments, provided that such instruments exist.
If the bond includes embedded options, the valuation is more difficult and combines option
pricing with discounting. Depending on the type of option, the option price as calculated is either
added to or subtracted from the price of the "straight" portion. This total is then the value of the
bond; the various yields can then be calculated for the total price. See further under Bond option.
Bond valuation
As above, the fair price of a straight bond (a bond with no embedded option; see Embedded
Option) is usually determined by discounting its expected cash flows at the appropriate discount
rate. The formula commonly applied is discussed initially. Although this present value
relationship reflects the theoretical approach to determining the value of a bond, in practice its
price is (usually) determined with reference to other, more liquid instruments. The two main
approaches, Relative pricing and Arbitrage-free pricing, are discussed next. Finally, where it is
important to recognise that future interest rates are uncertain and that the discount rate is not
adequately represented by a single fixed number - for example when an option is written on the
bond in question - stochastic calculus may be employed.
[edit] Present value approach
Below is the formula for calculating a bond's price, which uses the basic present value (PV)
formula for a given discount rate:[1] (This formula assumes that a coupon payment has just been
made; see below for adjustments on other dates.)
F = face value
iF = contractual interest rate
C = F * iF = coupon payment (periodic interest payment)
N = number of payments
i = market interest rate, or required yield, or yield to maturity (see below)
M = value at maturity, usually equals face value
P = market price of bond

If the market price of bond is less than its face value (par value), the bond is selling at a
discount. Conversely, if the market price of bond is greater than its face value, the bond is
selling at a premium.[2]
[edit] Relative price approach
Under this approach, the bond will be priced relative to a benchmark, usually a government
security; see Relative valuation. Here, the yield to maturity on the bond is determined based on
the bond's Credit rating relative to a government security with similar maturity or duration; see
Credit spread (bond). The better the quality of the bond, the smaller the spread between its
required return and the YTM of the benchmark. This required return, i in the formula, is then
used to discount the bond cash flows as above to obtain the price.
[edit] Arbitrage-free pricing approach
Under this approach, the bond price will reflect its arbitrage-free price. Here, each cash flow
(coupon or face) is separately discounted at the same rate as a zero-coupon bond corresponding
to the coupon date, and of equivalent credit worthiness (if possible, from the same issuer as the
bond being valued, or if not, with the appropriate credit spread). Here, in general, we apply the
rational pricing logic relating to "Assets with identical cash flows". In detail: (1) the bond's
coupon dates and coupon amounts are known with certainty. Therefore (2) some multiple (or
fraction) of zero-coupon bonds, each corresponding to the bond's coupon dates, can be specified
so as to produce identical cash flows to the bond. Thus (3) the bond price today must be equal to
the sum of each of its cash flows discounted at the discount rate implied by the value of the
corresponding ZCB. Were this not the case, (4) the abitrageur could finance his purchase of
whichever of the bond or the sum of the various ZCBs was cheaper, by short selling the other,
and meeting his cash flow commitments using the coupons or maturing zeroes as appropriate.
Then (5) his "risk free", arbitrage profit would be the difference between the two values. See
Rational pricing: Fixed income securities.
[edit] Stochastic calculus approach
The following is a partial differential equation (PDE) in stochastic calculus which is satisfied by
any zero-coupon bond. This methodology recognises that since future interest rates are uncertain,
the discount rate referred to above is not adequately represented by a single fixed number.

The solution to the PDE is given in [3]

where is the expectation with respect to risk-neutral probabilities, and R(t,T) is a random
variable representing the discount rate; see also Martingale pricing.
Practically, to determine the bond price, specific short rate models are employed here. However,
when using these models, it is often the case that no closed form solution exists, and a lattice- or
simulation-based implementation of the model in question is employed. The approaches
commonly used are:
• the CIR model
• the Black-Derman-Toy model
• the Hull-White model
• the HJM framework
• the Chen model.
[edit] Clean and dirty price
Main articles: Clean price and Dirty price
When the bond is not valued precisely on a coupon date, the calculated price, using the methods
above, will incorporate accrued interest: i.e. any interest due to the owner of the bond since the
previous coupon date; see day count convention. The price of a bond which includes this accrued
interest is known as the "dirty price" (or "full price" or "all in price" or "Cash price"). The "clean
price" is the price excluding any interest that has accrued. Clean prices are generally more stable
over time than dirty prices. This is because the dirty price will drop suddenly when the bond goes
"ex interest" and the purchaser is no longer entitled to receive the next coupon payment. In many
markets, it is market practice to quote bonds on a clean-price basis. When a purchase is settled,
the accrued interest is added to the quoted clean price to arrive at the actual amount to be paid.
[edit] Yield and price relationships
Once the price or value has been calculated, various yields - which relate the price of the bond to
its coupons - can then be determined.
[edit] Yield to Maturity
The yield to maturity is the discount rate which returns the market price of the bond; it is
identical to r (required return) in the above equation. YTM is thus the internal rate of return of an
investment in the bond made at the observed price. Since YTM can be used to price a bond, bond
prices are often quoted in terms of YTM.
To achieve a return equal to YTM, i.e. where it is the required return on the bond, the bond
owner must:
• buy the bond at price P0,
• hold the bond until maturity, and
• redeem the bond at par.
[edit] Coupon yield
The coupon yield is simply the coupon payment (C) as a percentage of the face value (F).
Coupon yield = C / F
Coupon yield is also called nominal yield.
[edit] Current yield
The current yield is simply the coupon payment (C) as a percentage of the (current) bond price
(P).
Current yield = C / P0.
[edit] Relationship
The concept of current yield is closely related to other bond concepts, including yield to
maturity, and coupon yield. The relationship between yield to maturity and the coupon rate is as
follows:
• When a bond sells at a discount, YTM > current yield > coupon yield.
• When a bond sells at a premium, coupon yield > current yield > YTM.
• When a bond sells at par, YTM = current yield = coupon yield amt
[edit] Price sensitivity
Main articles: Bond duration and Bond convexity
The sensitivity of a bond's market price to interest rate (i.e. yield) movements is measured by its
duration, and, additionally, by its convexity.
Duration is a linear measure of how the price of a bond changes in response to interest rate
changes. It is approximately equal to the percentage change in price for a given change in yield,
and may be thought of as the elasticity of the bond's price with respect to discount rates. For
example, for small interest rate changes, the duration is the approximate percentage by which the
value of the bond will fall for a 1% per annum increase in market interest rate. So the market
price of a 17-year bond with a duration of 7 would fall about 7% if the market interest rate (or
more precisely the corresponding force of interest) increased by 1% per annum.
Convexity is a measure of the "curvature" of price changes. It is needed because the price is not a
linear function of the discount rate, but rather a convex function of the discount rate.
Specifically, duration can be formulated as the first derivative of the price with respect to the
interest rate, and convexity as the second derivative; see Bond duration closed-form formula;
Bond convexity closed-form formula). Continuing the above example, for a more accurate
estimate of sensitivity, the convexity score would be multiplied by the square of the change in
interest rate, and the result added to the value derived by the above linear formula.
[edit] Accounting treatment
In accounting for liabilities, any bond discount or premium must be amortized over the life of
bond. A number of methods may be used for this depending on applicable accounting rules. One
possibility is that amortization amount in each period is calculated from the following formula:

an + 1 = amortization amount in period number "n+1"

an + 1 = | iP − C | (1 + i)n
Bond Discount or Bond Premium = | F − P | = a1 + a2 + ... + aN

Bond Discount or Bond Premium =

Bond Valuation

What Does Bond Valuation Mean?

A technique for determining the fair value of a particular bond. Bond valuation
includes calculating the present value of the bond's future interest payments, also known as its
cash flow, and the bond's value upon maturity, also known as its face value or par value. Because
a bond's par value and interest payments are fixed, an investor uses bond valuation to determine
what rate of return is required for an investment in a particular bond to be worthwhile.

Investopedia explains Bond Valuation

Bond valuation is only one of the factors investors consider in determining whether to invest in a
particular bond. Other important considerations are: the issuing company's creditworthiness,
which determines whether a bond is investment-grade or junk; the bond's price appreciation
potential, as determined by the issuing company's growth prospects; and prevailing market
interest rates and whether they are projected to go up or down in the future.
 Types of swaps
The five generic types of swaps, in order of their quantitative importance, are: interest rate
swaps, currency swaps, credit swaps, commodity swaps and equity swaps. There are also many
other types.
[edit] Interest rate swaps
Main article: Interest rate swap

A is currently paying floating, but wants to pay fixed. B is currently paying fixed but wants to
pay floating. By entering into an interest rate swap, the net result is that each party can 'swap'
their existing obligation for their desired obligation. Normally the parties do not swap payments
directly, but rather, each sets up a separate swap with a financial intermediary such as a bank. In
return for matching the two parties together, the bank takes a spread from the swap payments.
The most common type of swap is a “plain Vanilla” interest rate swap. It is the exchange of a
fixed rate loan to a floating rate loan. The life of the swap can range from 2 years to over 15
years. The reason for this exchange is to take benefit from comparative advantage. Some
companies may have comparative advantage in fixed rate markets while other companies have a
comparative advantage in floating rate markets. When companies want to borrow they look for
cheap borrowing i.e. from the market where they have comparative advantage. However this
may lead to a company borrowing fixed when it wants floating or borrowing floating when it
wants fixed. This is where a swap comes in. A swap has the effect of transforming a fixed rate
loan into a floating rate loan or vice versa. For example, party B makes periodic interest
payments to party A based on a variable interest rate of LIBOR +70 basis points. Party A in
return makes periodic interest payments based on a fixed rate of 8.65%. The payments are
calculated over the notional amount. The first rate is called variable, because it is reset at the
beginning of each interest calculation period to the then current reference rate, such as LIBOR.
In reality, the actual rate received by A and B is slightly lower due to a bank taking a spread.
[edit] Currency swaps
Main article: Currency swap
A currency swap involves exchanging principal and fixed rate interest payments on a loan in one
currency for principal and fixed rate interest payments on an equal loan in another currency. Just
like interest rate swaps, the currency swaps also are motivated by comparative advantage.
Currency swaps entail swapping both principal and interest between the parties, with the
cashflows in one direction being in a different currency than those in the opposite direction.
[edit] Commodity swaps
Main article: Commodity swap
A commodity swap is an agreement whereby a floating (or market or spot) price is exchanged for
a fixed price over a specified period. The vast majority of commodity swaps involve crude oil.
[edit] Equity Swap
Main article: Equity swap
An equity swap is a special type of total return swap, where the underlying asset is a stock, a
basket of stocks, or a stock index. Compared to actually owning the stock, in this case you do not
have to pay anything up front, but you do not have any voting or other rights that stock holders
do.
[edit] Credit default swaps
Main article: Credit default swap
A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series of
payments to the seller and, in exchange, receives a payoff if a credit instrument - typically a
bond or loan - goes into default (fails to pay). Less commonly, the credit event that triggers the
payoff can be a company undergoing restructuring, bankruptcy or even just having its credit
rating downgraded. CDS contracts have been compared with insurance, because the buyer pays a
premium and, in return, receives a sum of money if one of the events specified in the contract
occur. Unlike an actual insurance contract the buyer is allowed to profit from the contract and
may also cover an asset to which the buyer has no direct exposure.
The five generic types of swaps, in order of their quantitative importance, are: interest rate
swaps, currency swaps, credit swaps, commodity swaps and equity swaps. There are also
many other types.
Interest rate swaps
The most common type of swap is a “plain Vanilla” interest rate swap. It is the exchange of a
fixed rate loan to a floating rate loan. The life of the swap can range from 2 years to over 15
years. The reason for this exchange is to take benefit from comparative advantage.
Some companies may have comparative advantage in fixed rate markets while other companies
have a comparative advantage in floating rate markets. When companies want to borrow they
look for cheap borrowing i.e. from the market where they have comparative advantage. However
this may lead to a company borrowing fixed when it wants floating or borrowing floating when it
wants fixed. This is where a swap comes in. A swap has the effect of transforming a fixed rate
loan into a floating rate loan or vice versa.

Currency swaps
A currency swap involves exchanging principal and fixed rate interest payments on a loan in one
currency for principal and fixed rate interest payments on an equal loan in another currency. Just
like interest rate swaps, the currency swaps also are motivated by comparative advantage.
Commodity swaps
A commodity swap is an agreement whereby a floating (or market or spot) price is exchanged for
a fixed price over a specified period. The vast majority of commodity swaps involve crude oil.

Equity swap

An equity swap is a special type of total return swap, where the underlying asset is a stock, a
basket of stocks, or a stock index. Compared to actually owning the stock, in this case you do not
have to pay anything up front, but you do not have any voting or other rights that stock holders
do have.
Credit default swaps

A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series of
payments to the seller and, in exchange, receives a payoff if a credit instrument - typically a bond
or loan - goes into default (fails to pay). Less commonly, the credit event that triggers the payoff
can be a company undergoing restructuring, bankruptcy or even just having its credit rating
downgraded. CDS contracts have been compared with insurance, because the buyer pays a
premium and, in return, receives a sum of money if one of the events specified in the contract
occur. Unlike an actual insurance contract the buyer is allowed to profit from the contract and
may also cover an asset to which the buyer has no direct exposure.
Other variations

There are myriad different variations on the vanilla swap structure, which are limited only by the
imagination of financial engineers and the desire of corporate treasurers and fund managers for
exotic structures.

* A total return swap is a swap in which party A pays the total return of an asset, and party B
makes periodic interest payments. The total return is the capital gain or loss, plus any interest or
dividend payments. Note that if the total return is negative, then party A receives this amount
from party B. The parties have exposure to the return of the underlying stock or index, without
having to hold the underlying assets. The profit or loss of party B is the same for him as actually
owning the underlying asset.
* An option on a swap is called a swaption. These provide one party with the right but not the
obligation at a future time to enter into a swap.
* A variance swap is an over-the-counter instrument that allows one to speculate on or hedge
risks associated with the magnitude of movement, a CMS, is a swap that allows the purchaser to
fix the duration of received flows on a swap.
* An Amortising swap is usually an interest rate swap in which the notional principal for the
interest payments declines during the life of the swap, perhaps at a rate tied to the prepayment of
a mortgage or to an interest rate benchmark such as the LIBOR.
Source: Wikipedia

Advanced Bond Concepts: Bond Pricing

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It is important for prospective bond buyers to know how to determine the price of a bond
because it will indicate the yield received should the bond be purchased. In this section, we will
run through some bond price calculations for various types of bond instruments.

Bonds can be priced at a premium, discount, or at par. If the bond's price is higher than its par
value, it will sell at a premium because its interest rate is higher than current prevailing rates. If
the bond's price is lower than its par value, the bond will sell at a discount because its interest
rate is lower than current prevailing interest rates. When you calculate the price of a bond, you
are calculating the maximum price you would want to pay for the bond, given the bond's coupon
rate in comparison to the average rate most investors are currently receiving in the bond market.
Required yield or required rate of return is the interest rate that a security needs to offer in order
to encourage investors to purchase it. Usually the required yield on a bond is equal to or greater
than the current prevailing interest rates.

Fundamentally, however, the price of a bond is the sum of the present values of all expected
coupon payments plus the present value of the par value at maturity. Calculating bond price is
simple: all we are doing is discounting the known future cash flows. Remember that to
calculate present value (PV) - which is based on the assumption that each payment is re-invested
at some interest rate once it is received--we have to know the interest rate that would earn us a
known future value. For bond pricing, this interest rate is the required yield. (If the concepts of
present and future value are new to you or you are unfamiliar with the calculations, refer to
Understanding the Time Value of Money.)

Here is the formula for calculating a bond's price, which uses the basic present value (PV)
formula:

C = coupon payment
 n = number of payments
i = interest rate, or required yield
M = value at maturity, or par value

The succession of coupon payments to be received in the future is referred to as an ordinary

annuity, which is a series of fixed payments at set intervals over a fixed period of time. (Coupons
on a straight bond are paid at ordinary annuity.) The first payment of an ordinary annuity occurs
one interval from the time at which the debt security is acquired. The calculation assumes this
time is the present.

You may have guessed that the bond pricing formula shown above may be tedious to calculate,
as it requires adding the present value of each future coupon payment. Because these payments
are paid at an ordinary annuity, however, we can use the shorter PV-of-ordinary-annuity formula
that is mathematically equivalent to the summation of all the PVs of future cash flows. This PV-
of-ordinary-annuity formula replaces the need to add all the present values of the future coupon.
The following diagram illustrates how present value is calculated for an ordinary annuity:

Each full moneybag on the top right represents the fixed coupon payments (future value)
received in periods one, two and three. Notice how the present value decreases for those coupon
payments that are further into the future the present value of the second coupon payment is worth
less than the first coupon and the third coupon is worth the lowest amount today. The farther into
the future a payment is to be received, the less it is worth today - is the fundamental concept for
which the PV-of-ordinary-annuity formula accounts. It calculates the sum of the present values
of all future cash flows, but unlike the bond-pricing formula we saw earlier, it doesn't
require that we add the value of each coupon payment. (For more on calculating the time value
of annuities, see Anything but Ordinary: Calculating the Present and Future Value of
Annuities and Understanding the Time Value of Money. )

By incorporating the annuity model into the bond pricing formula, which requires us to also
include the present value of the par value received at maturity, we arrive at the following
formula:

Let's go through a basic example to find the price of a plain vanilla bond.

Example 1: Calculate the price of a bond with a par value of $1,000 to be paid in ten years, a
coupon rate of 10%, and a required yield of 12%. In our example we'll assume that coupon
payments are made semi-annually to bond holders and that the next coupon payment is expected
in six months. Here are the steps we have to take to calculate the price:

1. Determine the Number of Coupon Payments: Because two coupon payments will be made
each year for ten years, we will have a total of 20 coupon payments.

2. Determine the Value of Each Coupon Payment: Because the coupon payments are semi-
annual, divide the coupon rate in half. The coupon rate is the percentage off the bond's par value.
As a result, each semi-annual coupon payment will be $50 ($1,000 X 0.05).

3. Determine the Semi-Annual Yield: Like the coupon rate, the required yield of 12% must be
divided by two because the number of periods used in the calculation has doubled. If we left the
required yield at 12%, our bond price would be very low and inaccurate. Therefore, the required
semi-annual yield is 6% (0.12/2).

4. Plug the Amounts Into the Formula:

From the above calculation, we have determined that the bond is selling at a discount; the bond
price is less than its par value because the required yield of the bond is greater than the coupon
rate. The bond must sell at a discount to attract investors, who could find higher interest
elsewhere in the prevailing rates. In other words, because investors can make a larger return in
the market, they need an extra incentive to invest in the bonds.

Accounting for Different Payment Frequencies

In the example above coupons were paid semi-annually, so we divided the interest rate and
coupon payments in half to represent the two payments per year. You may be now wondering
whether there is a formula that does not require steps two and three outlined above, which are
required if the coupon payments occur more than once a year. A simple modification of the
above formula will allow you to adjust interest rates and coupon payments to calculate a bond
price for any payment frequency:

Notice that the only modification to the original formula is the addition of "F", which represents
the frequency of coupon payments, or the number of times a year the coupon is paid. Therefore,
for bonds paying annual coupons, F would have a value of one. Should a bond pay quarterly
payments, F would equal four, and if the bond paid semi-annual coupons, F would be two.

Pricing Zero-Coupon Bonds

So what happens when there are no coupon payments? For the aptly-named zero-coupon bond,
there is no coupon payment until maturity. Because of this, the present value of annuity formula
is unnecessary. You simply calculate the present value of the par value at maturity. Here's a
simple example:
Example 2(a): Let's look at how to calculate the price of a zero-coupon bond that is maturing in
five years, has a par value of $1,000 and a required yield of 6%.

1. Determine the Number of Periods: Unless otherwise indicated, the required yield of most
zero-coupon bonds is based on a semi-annual coupon payment. This is because the interest on a
zero-coupon bond is equal to the difference between the purchase price and maturity value, but
we need a way to compare a zero-coupon bond to a coupon bond, so the 6% required yield must
be adjusted to the equivalent of its semi-annual coupon rate. Therefore, the number of periods for
zero-coupon bonds will be doubled, so the zero coupon bond maturing in five years would have
ten periods (5 x 2).

2. Determine the Yield: The required yield of 6% must also be divided by two because the
number of periods used in the calculation has doubled. The yield for this bond is 3% (6% / 2).

3. Plug the amounts into the formula:

You should note that zero-coupon bonds are always priced at a discount: if zero-coupon bonds
were sold at par, investors would have no way of making money from them and therefore no
incentive to buy them.

Pricing Bonds between Payment Periods

Up to this point we have assumed that we are purchasing bonds whose next coupon payment
occurs one payment period away, according to the regular payment-frequency pattern. So far, if
we were to price a bond that pays semi-annual coupons and we purchased the bond today, our
calculations would assume that we would receive the next coupon payment in exactly six
months. Of course, because you won't always be buying a bond on its coupon payment date, it's
important you know how to calculate price if, say, a semi-annual bond is paying its next coupon
in three months, one month, or 21 days.

Determining Day Count

To price a bond between payment periods, we must use the appropriate day-count convention.
Day count is a way of measuring the appropriate interest rate for a specific period of time. There
is actual/actual day count, which is used mainly for Treasury securities. This method counts the
exact number of days until the next payment. For example, if you purchased a semi-
annual Treasury bond on March 1, 2003, and its next coupon payment is in four months (July 1,
2003), the next coupon payment would be in 122 days:

Time Period = Days Counted

March 1-31 = 31 days
April 1-30 = 30 days
May 1-31 = 31 days
June 1-30 = 30 days
July 1 = 0 days
Total Days = 122 days

To determine the day count, we must also know the number of days in the six-month period of
the regular payment cycle. In these six months there are exactly 182 days, so the day count of the
Treasury bond would be 122/182, which means that out of the 182 days in the six-month period,
the bond still has 122 days before the next coupon payment. In other words, 60 days of the
payment period (182 - 122) have already passed. If the bondholder sold the bond today, he or she
must be compensated for the interest accrued on the bond over these 60 days.

(Note that if it is a leap year, the total number of days in a year is 366 rather than 365.)

For municipal and corporate bonds, you would use the 30/360 day count convention, which is
much simpler as there is no need to remember the actual number of days in each year and month.
This count convention assumes that a year consists of 360 days and each month consists of 30
days. As an example, assume the above Treasury bond was actually a semi-annual corporate
bond. In this case, the next coupon payment would be in 120 days.

Time Period = Days Counted

March 1-30 = 30 days
April 1-30 = 30 days
May 1-30 = 30 days
June 1-30 = 30 days
July 1 = 0 days
Total Days = 120 days

As a result, the day count convention would be 120/180, which means that 66.7% of the coupon
period remains. Notice that we end up with almost the same answer as the actual/actual day
count convention above: both day-count conventions tell us that 60 days have passed into the
payment period.

Determining Interest Accrued

Accrued interest is the fraction of the coupon payment that the bond seller earns for holding the
bond for a period of time between bond payments. The bond price's inclusion of any interest
accrued since the last payment period determines whether the bond's price is "dirty" or
"clean." Dirty bond prices include any accrued interest that has accumulated since the last
coupon payment while clean bond prices do not. In newspapers, the bond prices quoted are often
clean prices.

However, because many of the bonds traded in the secondary market are often traded in between
coupon payment dates, the bond seller must be compensated for the portion of the coupon
payment he or she earns for holding the bond since the last payment. The amount of the coupon
payment that the buyer should receive is the coupon payment minus accrued interest. The
following example will make this concept more clear.

Example 3: On March 1, 2003, Francesca is selling a corporate bond with a face value of $1,000
and a 7% coupon paid semi-annually. The next coupon payment after March 1, 2003, is expected
on June 30, 2003. What is the interest accrued on the bond?

1. Determine the Semi-Annual Coupon Payment: Because the coupon payments are semi-
annual, divide the coupon rate in half, which gives a rate of 3.5% (7% / 2). Each semi-annual
coupon payment will then be $35 ($1,000 X 0.035).

2. Determine the Number of Days Remaining in the Coupon Period: Because it is a corporate
bond, we will use the 30/360 day-count convention.

Time Period = Days Counted

March 1-30 = 30 days
April 1-30 = 30 days
May 1-30 = 30 days
June 1-30 = 30 days
Total Days = 120 days

There are 120 days remaining before the next coupon payment, but because the coupons are paid
semi-annually (two times a year), the regular payment period if the bond is 180 days, which,
according to the 30/360 day count, is equal to six months. The seller, therefore, has accumulated
60 days worth of interest (180-120).

3. Calculate the Accrued Interest: Accrued interest is the fraction of the coupon payment that
the original holder (in this case Francesca) has earned. It is calculated by the following formula:

In this example, the interest accrued by Francesca is $11.67. If the buyer only paid her the clean
price, she would not receive the $11.67 to which she is entitled for holding the bond for those 60
days of the 180-day coupon period.

Now you know how to calculate the price of a bond, regardless of when its next coupon will be
paid. Bond price quotes are typically the clean prices, but buyers of bonds pay the dirty, or full
price. As a result, both buyers and sellers should understand the amount for which a bond should
be sold or purchased. In addition, the tools you learned in this section will better enable you to
learn the relationship between coupon rate, required yield and price as well as the reasons for
which bond prices change in the market.

Next: Advanced Bond Concepts: Yield and Bond Price

Table of Contents
1) Advanced Bond Concepts: Introduction
2) Advanced Bond Concepts: Bond Type Specifics
3) Advanced Bond Concepts: Bond Pricing
4) Advanced Bond Concepts: Yield and Bond Price
5) Advanced Bond Concepts: Term Structure of Interest Rates
6) Advanced Bond Concepts: Duration
7) Advanced Bond Concepts: Convexity
8) Advanced Bond Concepts: Formula Cheat Sheet
9) Advanced Bond Concepts: Conclusion

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Filed Under: Bonds, Financial Theory, Fixed Income

Speculation
In finance, speculation is a financial action that does not promise safety of the initial investment
along with the return on the principal sum.[1] Speculation typically involves the lending of money
for the purchase of assets, equity or debt but in a manner that has not been given thorough
analysis or is deemed to have low margin of safety or a significant risk of the loss of the
principal investment. The term, "speculation," which is formally defined as above in Graham and
Dodd's 1934 text, Security Analysis, contrasts with the term "investment," which is a financial
operation that, upon thorough analysis, promises safety of principal and a satisfactory return.[1]
In a financial context, the terms "speculation" and "investment" are actually quite specific. For
instance, although the word "investment" is commonly used to mean any act of placing money in
a financial vehicle with the intent of producing returns over a period of time, most ventured
money—including funds placed in the world's stock markets—is technically not investment, but
speculation.
Speculators may rely on an asset appreciating in price due to any of a number of factors that
cannot be well enough understood by the speculator to make an investment-quality decision.
Some such factors are shifting consumer tastes, fluctuating economic conditions, buyers'
changing perceptions of the worth of a stock security, economic factors associated with market
timing, the factors associated with solely chart-based analysis, and the many influences over the
short-term movement of securities.
There are also some financial vehicles that are, by definition, speculation. For instance, trading
commodity futures contracts, such as for oil and gold, is, by definition, speculation. Short selling
is also, by definition, speculative.
Financial speculation can involve the trade (buying, holding, selling) and short-selling of stocks,
bonds, commodities, currencies, collectibles, real estate, derivatives, or any valuable financial
instrument to attempt to profit from fluctuations in its price irrespective of its underlying value.
In architecture, speculation is used to determine works that show a strong conceptual and
strategic focus

Investment vs. speculation

Identifying speculation can be best done by distinguishing it from investment. According to Ben
Graham in Intelligent Investor, the prototypical defensive investor is "...one interested chiefly in
safety plus freedom from bother." He admits, however, that "...some speculation is necessary and
unavoidable, for in many common-stock situations, there are substantial possibilities of both
profit and loss, and the risks therein must be assumed by someone."[3] Many long-term investors,
even those who buy and hold for decades, may be classified as speculators, excepting only the
rare few who are primarily motivated by income or safety of principal and not eventually selling
at a profit.[citation needed]
Speculating is the assumption of risk in anticipation of gain but recognizing a higher than
average possibility of loss. The term speculation implies that a business or investment risk can be
analyzed and measured, and its distinction from the term Investment is one of degree of risk. It
differs from gambling, which is based on random outcomes.[4] There is nothing in the act of
speculating or investing that suggests holding times have anything to do with the difference in
the degree of risk separating speculation from investing.[citation needed]
[edit] The economic benefits of speculation
[edit] Sustainable consumption level

Speculation usually involves more risks than investment.

The well known[says who?] speculator Victor Niederhoffer, in "The Speculator as Hero"[5] describes
the benefits of speculation:
Let's consider some of the principles that explain the causes of shortages and surpluses and the
role of speculators. When a harvest is too small to satisfy consumption at its normal rate,
speculators come in, hoping to profit from the scarcity by buying. Their purchases raise the price,
thereby checking consumption so that the smaller supply will last longer. Producers encouraged
by the high price further lessen the shortage by growing or importing to reduce the shortage. On
the other side, when the price is higher than the speculators think the facts warrant, they sell.
This reduces prices, encouraging consumption and exports and helping to reduce the surplus.
Another service provided by speculators to a market is that by risking their own capital in the
hope of profit, they add liquidity to the market and make it easier for others to offset risk,
including those who may be classified as hedgers and arbitrageurs.
[edit] Market efficiency and liquidity
If a certain market—for example, pork bellies—had no speculators, then only producers (hog
farmers) and consumers (butchers, etc.) would participate in that market. With fewer players in
the market, there would be a larger spread between the current bid and ask price of pork bellies.
Any new entrant in the market who wants to either buy or sell pork bellies would be forced to
accept an illiquid market and market prices that have a large bid-ask spread or might even find it
difficult to find a co-party to buy or sell to. A speculator (e.g., a pork dealer) may exploit the
difference in the spread and, in competition with other speculators, reduce the spread, thus
creating a more efficient market.
[edit] Bearing risks
Speculators also sometimes perform a very important risk bearing role that is beneficial to
society. For example, a farmer might be considering planting corn on some unused farmland.
Alas, he might not want to do so because he is concerned that the price might fall too far by
harvest time. By selling his crop in advance at a fixed price to a speculator, the farmer can hedge
the price risk and is now willing to plant the corn. Thus, speculators can actually increase
production through their willingness to take on risk.
[edit] Finding environmental and other risks
Hedge funds that do fundamental analysis "are far more likely than other investors to try to
identify a firm’s off-balance-sheet exposures", including "environmental or social liabilities
present in a market or company but not explicitly accounted for in traditional numeric valuation
or mainstream investor analysis", and hence make the prices better reflect the true quality of
operation of the firms.[6]
[edit] Shorting
Shorting may act as a “canary in a coal mine” to stop unsustainable practices earlier and thus
reduce damages and forming market bubbles.[6]
[edit] Some side effects
Auctions are a method of squeezing out speculators from a transaction, but they may have their
own perverse effects; see winner's curse. The winner's curse is however not very significant to
markets with high liquidity for both buyers and sellers, as the auction for selling the product and
the auction for buying the product occur simultaneously, and the two prices are separated only by
a relatively small spread. This mechanism prevents the winner's curse phenomenon from causing
mispricing to any degree greater than the spread.[citation needed]
Speculation can also cause prices to deviate from their intrinsic value if speculators trade on
misinformation, or if they are just plain wrong. This creates a positive feedback loop in which
prices rise dramatically above the underlying value or worth of the items. This is known as an
economic bubble. Such a period of increasing speculative purchasing is typically followed by
one of speculative selling in which the price falls significantly, in extreme cases this may lead to
crashes.
In 1936 John Maynard Keynes wrote: "Speculators may do no harm as bubbles on a steady
stream of enterprise. But the situation is serious when enterprise becomes the bubble on a
whirlpool of speculation. (1936:159)"[7] Mr Keynes himself enjoyed speculation to the fullest,
running an early precursor of a hedge fund. As the Bursar of the Cambridge University King's
College, he managed two investment funds, one of which, called Chest Fund, invested not only
in the then 'emerging' market US stocks, but also periodically included commodity futures and
foreign currencies, albeit to a smaller extent (see Chua and Woodward, 1983) . His fund
achieved positive returns in almost every year, averaging 13% p.a., even during the Great
Depression, thanks to very modern investment strategies, which included inter-market
diversification (i.e., invested not only in stocks but also commodities and currencies) as well as
shorting, i.e., selling borrowed stocks or futures to make money on falling prices, which Keynes
advocated among the principles of successful investment in his 1933 report ("a balanced
investment position [...] and if possible, opposed risks.") [8]
According to Ziemba and Ziemba (2007), Keynes risk-taking reached 'cowboy' proportions, i.e.
80% of the maximum rationally justifiable levels (of the so called Kelly criterion), with overall
return volatility approximately three times higher than the stock market index benchmark. Such
levels of volatility, responsible for his spectacular investment performance, would be achievable
today only through the most aggressive instruments (such as 3:1 leveraged exchange-traded
funds). He chose modern speculation techniques practiced today by hedge funds, which are quite
different from the simple buy-and-hold long-term investing.[9]
It is a controversial point whether the presence of speculators increases or decreases the short-
term volatility in a market. Their provision of capital and information may help stabilize prices
closer to their true values. On the other hand, crowd behavior and positive feedback loops in
market participants may also increase volatility at times.

Investment
From Wikipedia, the free encyclopedia
For other uses, see Investment (disambiguation).
Investment has different meanings in finance and economics. In Finance investment is putting
money into something with the expectation of gain, that upon thorough analysis, has a high
degree of security of principle, as well as security of return, within an expected period of time.[1]
In contrast putting money into something with an expectation of gain without thorough analysis,
without security of principal, and without security of return is speculation or gambling.
Investment is related to saving or deferring consumption. Investment is involved in many areas
of the economy, such as business management and finance whether for households, firms, or
governments.
To avoid speculation an investment must be either directly backed by the pledge of sufficient
collateral or insured by sufficient assets pledged by a third party. A thoroughly analyzed loan of
money backed by collateral with greater immediate value than the loan amount may be
considered an investment. A financial instrument that is insured by the pledge of assets from a
third party, such as as a deposit in a financial institution insured by a government agency may be
considered an investment. Examples of these agencies include, in the United States, the
Securities Investor Protection Corporation, Federal Deposit Insurance Corporation, or National
Credit Union Administration, or in Canada, the Canada Deposit Insurance Corporation.
Promoters of and news sources that report on speculative financial transactions such as stocks,
mutual finds, real estate, oil and gas leases, commodities, and futures often inaccurately or
misleadingly describe speculative schemes as investment.
Investment: thorough analysis and security Speculation: analysis and some risk Gambling: lack
of analysis and lack of safet

What is Investment

Investment is the commitment of money or capital to purchase financial

instruments or other assets in order to gain profitable returns in the form of interest, income, or
appreciation of the value of the instrument. Investment is related to saving or deferring
consumption.

An investment involves the choice by an individual or an organization such as a pension fund,

after some analysis or thought, to place or lend money in a vehicle, instrument or asset, such
as property, commodity, stock, bond, financial derivatives (e.g. futures or options), or the
foreign asset denominated in foreign currency, that has certain level of risk and provides the
possibility of generating returns over a period of time. When an asset is bought or a given
amount of money is invested in the bank, there is anticipation that some return will be received
from the investment in the future.

Investment is a term frequently used in the fields of economics, business management and
finance. It can mean savings alone, or savings made through delayed consumption. Investment
can be divided into different types according to various theories and principles.

While dealing with the various options of investment, the defining terms of investment need to
be kept in mind.

Investment in terms of Economics

According to economic theories, investment is defined as the per-unit production of goods,
which have not been consumed, but will however, be used for the purpose of future production.
Examples of this type of investments are tangible goods like construction of a factory or bridge
and intangible goods like 6 months of on-the-job training. In terms of national production and
income, Gross Domestic Product (GDP) has an essential constituent, known as gross investment.

Investment in Terms of Business Management:

According to business management theories, investment refers to tangible assets like machinery
and equipments and buildings and intangible assets like copyrights or patents and goodwill. The
decision for investment is also known as capital budgeting decision, which is regarded as one of
the key decisions.

Investment in Terms of Finance:

In finance, investment refers to the purchasing of securities or other financial assets from the
capital market. It also means buying money market or real properties with high market liquidity.
Some examples are gold, silver, real properties, and precious items.

Financial investments are in stocks, bonds, and other types of security investments. Indirect
financial investments can also be done with the help of mediators or third parties, such as
pension funds, mutual funds, commercial banks, and insurance companies.

Personal Finance:
According to personal finance theories, an investment is the implementation of money for buying
shares, mutual funds or assets with capital risk.

Real Estate:
According to real estate theories, investment is referred to as money utilized for buying property
for the purpose of ownership or leasing. This also involves capital risk.

Commercial Real Estate:

Commercial real estate involves a real estate investment in properties for commercial purposes
such as renting.

Residential Real Estate:

This is the most basic type of real estate investment, which involves buying houses as real estate
properties.

Risk
Risk is the potential that a chosen action or activity (including the choice of inaction) will lead to
a loss (an undesirable outcome). The notion implies that a choice having an influence on the
outcome exists (or existed). Potential losses themselves may also be called "risks". Almost any
human endeavour carries some risk, but some are much more risky than others.

Contents
[hide]

To understand the difference between risk and uncertainty begin

by exploring what is meant by "risk." Like other terms in this chapter, the term "risk" has many
different meanings. If you enter "risk definition" into Google you will get over twenty-five
definitions; some are redundant, but there is little consistency. A few definitions that are
important here are:
 • In technology and economics, risk is expressed as an expected value that an event will be
accompanied by undesirable consequences. It is measured by both the probability of the
event and the seriousness of the consequences. For example, the probability that a
bearing will fail in five years is .001 percent. The consequence of the bearing failing is
that the engine it bears will stop running. These two combine in a single value that
communicates risk.
• In planning, risk is what can happen that will cause the project to fall behind schedule or
go over cost. During planning, the known-unknowns are risk.
• In management, risk is the possibility that outcomes will be different from what we
expect. It is the effort to manage both the known-unknowns and unknown-unknowns.
This event-focused view of risk held in the technology and economics fields is too restrictive
during the decision-making process. This is because the largest risks are inherent in the
uncertainty of information and the knowledge and models on which decisions are based.
Decision risk includes:
• The potential for making a less-than-satisfactory decision based on limitations in the
certainty of the requirements
• The accuracy of best guesses about parameter values and models
• The completeness of the understanding of the situation and its physics
• The consistency of the team's parameter and model interpretation
• The team's differences in viewpoints about what is important
Planning and management risk are the result of what is uncertain and unknown—decision risk.
Decision risk has little to do with events (as in traditional risk analysis) and much to do with
what is known and the decisions based on this knowledge. Further, this type of risk cannot be
well-modeled using standard probabilities (often called "frequentist" probabilities, the stuff you
may have studied in school) and must use Bayesian methods. This is not to say that traditional
methods are unimportant, only that decision risk has not been well addressed and is key in early-
systems development.
Worded another way, risk traditionally amounts to answering:
• What can go wrong? A system fails.
• How likely is it to happen? Probability depends on past statistics and model results.
• What are the consequences? Money, time, and possibly even lives are wasted.
During decision-making, risks are inherent in uncertain knowledge, information, and models.
Uncertainty creates risk that a poor decision will be made; the questions are then answered this
way:
• What can go wrong? A poor choice is made.
• How likely is it to happen? Probability depends on uncertain knowledge and the team's
interpretation of information and models.
• What are the consequences? Money, time, and possibly lives are wasted.
All of this is good background, but managers are really only interested in answering three
questions:
• What can go wrong if I choose option X?
 • How likely is it?
• What is the impact?
One thing is consistent in this discussion:
Without uncertainty, there is no risk.
A corollary is that the more uncertainty, the higher the risk of making a poor decision. Thus, a
major goal in decision-making is to manage the uncertainty, especially decision or knowledge
uncertainty.
The methods supplied by Robust Decisions help you manage four types of risk:
• Envisioning Risk: The risk of solving the wrong problem
• Ideation Risk: The risk of not developing good alternatives
• Evaluation Risk: The risk of choosing a poor alternative
• Strategic Risk: The risk of not following a beneficial strategy
There is a fifth type not addressed:
• Execution Risk: The risk of not being able to implement the decision
Using the Accord tool suite allows you to manage uncertainty and thus decision risk removing
concern for the difference between risk and uncertainty. An introduction to managing
uncertainty and risk can be found on a companion page.

Macro Risk Levels

On a macro (large scale) level there are two main types of risk, these are systematic risk and
unsystematic risk.
• Systematic risk is the risk that cannot be reduced or predicted in any manner and it is
almost impossible to predict or protect yourself against this type of risk. Examples of this
type of risk include interest rate increases or government legislation changes. The
smartest way to account for this risk, is to simply acknowledge that this type of risk will
occur and plan for your investment to be affected by it.
• Unsystematic risk is risk that is specific to an assets features and can usually be
eliminated through a process called diversification (refer below). Examples of this type of
risk include employee strikes or management decision changes.

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Micro Risk Levels

The Failure of Risk Management: Why It’s Broken and How to Fix It
An essential guide to the calibrated risk analysis approach. The Failure of Risk
Management takes a close look at misused and misapplied basic analysis methods and
shows how some of the most popular “risk management” methods are no better than
astrology! [read more]
While the above risk types are the macro scale levels of risk, there are also some more important
micro (small scale) types of risks that are important when talking about the valuation of a stock
or bond. These include:
• Business Risk - The uncertainty of income caused by the nature of a companies business
measured by a ratio of operating earnings (income flows of the firm). This means that the
less certain you are about the income flows of a firm, the less certain the income will
flow back to you as an investor. The sources of business risk mainly arises from a
companies products/services, ownership support, industry environment, market position,
management quality etc. An example of business risk could include a rubbish company
that typically would experience stable income and growth over time and would have a
low business risk compared to a steel company whereby sales and earnings fluctuate
according to need for steel products and typically would have a higher business risk.
• Liquidity Risk – The uncertainty introduced by the secondary market for a company to
meet its future short term financial obligations. When an investor purchases a security,
they expect that at some future period they will be able to sell this security at a profit and
redeem this value as cash for consumption - this is the liquidity of an investment, its
ability to be redeemable for cash at a future date. Generally, as we move up the asset
allocation table - the liquidity risk of an investment increases.
• Financial Risk - Financial risk is the risk borne by equity holders (refer Shares section)
due to a firms use of debt. If the company raises capital by borrowing money, it must pay
back this money at some future date plus the financing charges (interest etc charged for
borrowing the money). This increases the degree of uncertainty about the company
because it must have enough income to pay back this amount at some time in the future.
• Exchange Rate Risk - The uncertainty of returns for investors that acquire foreign
investments and wish to convert them back to their home currency. This is particularly
important for investors that have a large amount of over-seas investment and wish to sell
and convert their profit to their home currency. If exchange rate risk is high - even though
a substantial profit may have been made overseas, the value of the home currency may be
less than the overseas currency and may erode a significant amount of the investments
earnings. That is, the more volatile an exchange rate between the home and investment
currency, the greater the risk of differing currency value eroding the investments value.
• Country Risk - This is also termed political risk, because it is the risk of investing funds
in another country whereby a major change in the political or economic environment
could occur. This could devalue your investment and reduce its overall return. This type
of risk is usually restricted to emerging or developing countries that do not have stable
economic or political arenas.
• Market Risk - The price fluctuations or volatility increases and decreases in the day-to-
day market. This type of risk mainly applies to both stocks and options and tends to
perform well in a bull (increasing) market and poorly in a bear (decreasing) market (see
bull vs bear). Generally with stock market risks, the more volatility within the market, the
more probability there is that your investment will increase or decrease.

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 Sources of Risk
There are various sources of risk, the three major ones being::
1. Business risk
2. Interest rate risk and
3. Market risk.
1. Business risk

As a holder of company securities like debentures, preference shares or equity shares, the
investor is exposed to the risk of poor business performance. There are various factors for
the cause of business risks like rigorous competition from the competitors, new
technologies emergence, development and arrival of substitute products in the market,
change in trends and fashion and thus shifts in consumer preferences, scarcity of inputs
for production, government policy changes etc. But apart from the above mentioned
causes, inefficient management may be the primary cause of business risk. Inefficient
management would lead to poor performance of the business resulting in lower or
insufficient profits or in certain cases, losses. It would affect the equity shareholders
when the business has insufficient profits left over to pay them their profits share’ after
meeting all the expenses and taxes. It would affect the debenture holders if the company
has insufficient funds even to pay their legal interest and principal dues.
2. Interest rate risk and

When the interest rate goes up, the market values of the existing fixed income securities
fall and when the interest rate goes down, the market value rises. Thus the changes in the
interest rate have an impact on the welfare of the investors. The prices of fixed income
securities change as a result of change in interest rate because the buyer of such securities
would not buy at its par value if its fixed interest rate is lower than the prevailing interest
rate on a similar security. For example, a bond that has a par value of $1,000 and a
coupon rate of 10% would sell at a discount if the interest rate increases from 10% to say,
13%. Apart from affecting the fixed income securities, the interest rate changes also
affects the equity shares indirectly.
3. Market risk.

The prices of the securities, particularly equity shares tend to fluctuate and become
volatile, even if the earning power of the corporate sector and the interest rate structure
remain more or less unchanged. The major cause for this fluctuation may be the
sentiment of the investors, which keep changing. Investors sometimes become bullish
and their investment horizons lengthen. So when the investors are optimistic, it would
 drive the share prices to greater heights. Inversely, when the investors are pessimistic,
become bearish, forces the share prices to fall. These bullish and bearish behaviors of the
investors affect the equity prices and the entire market as a whole, transforming into a
greater market risk.

Developed J. Welles Wilder, the Relative Strength Index (RSI) is a

momentum oscillator that measures the speed and change of price movements. RSI oscillates
between zero and 100. Traditionally, and according to Wilder, RSI is considered overbought
when above 70 and oversold when below 30. Signals can also be generated by looking for
divergences, failure swings and centerline crossovers. RSI can also be used to identify the
general trend.
RSI is an extremely popular momentum indicator that has been featured in a number of articles,
interviews and books over the years. In particular, Constance Brown's book, Technical Analysis
for the Trading Professional, features the concept of bull market and bear market ranges for RSI.
Andrew Cardwell, Brown's RSI mentor, introduced positive and negative reversals for RSI. In
addition, Cardwell turned the notion of divergence, literally and figuratively, on its head.
Wilder features RSI in his 1978 book, New Concepts in Technical Trading Systems. This book
also includes the Parabolic SAR, Average True Range and the Directional Movement Concept
(ADX). Despite being developed before the computer age, Wilder's indicators have stood the test
of time and remain extremely popular.
Calculation
100
RSI = 100 - --------
1 + RS

RS = Average Gain / Average Loss

To simplify the calculation explanation, RSI has been broken down into its basic components:
RS, Average Gain and Average Loss. This RSI calculation is based on 14 periods, which is the
default suggested by Wilder in his book. Losses are expressed as positive values, not negative
values.
The very first calculations for average gain and average loss are simple 14 period averages.
• First Average Gain = Sum of Gains over the past 14 periods / 14.
• First Average Loss = Sum of Losses over the past 14 periods / 14
The second, and subsequent, calculations are based on the prior averages and the current gain
loss:
• Average Gain = [(previous Average Gain) x 13 + current Gain] / 14.
• Average Loss = [(previous Average Loss) x 13 + current Loss] / 14.
Taking the prior value plus the current value is a smoothing technique similar to that used in
exponential moving average calculation. This also means that RSI values become more accurate
as the calculation period extends. SharpCharts uses at least 250 data points prior to the starting
date of any chart (assuming that much data exists) when calculating its RSI values. To exactly
replicate our RSI numbers, a formula will need at least 250 data points.
Wilder's formula normalizes RS and turns it into an oscillator that fluctuates between zero and
100. In fact, a plot of RS looks exactly the same as a plot of RSI. The normalization step makes
it easier to identify extremes because RSI is range bound. RSI is 0 when the Average Gain equals
zero. Assuming a 14-period RSI, a zero RSI value means prices moved lower all 14 periods.
There were no gains to measure. RSI is 100 when the Average Loss equals zero. This means
prices moved higher all 14 periods. There were no losses to measure.

The default look-back period for RSI is 14, but this can be lowered to increase sensitivity or
raised to decrease sensitivity. 10-day RSI is more likely to reach overbought or oversold levels
than 20-day RSI. The look-back parameters also depend on a security's volatility. 14-day RSI for
internet retailer Amazon (AMZN) is more likely to become overbought or oversold than 14-day
RSI for Duke Energy (DUK), a utility.
RSI is considered overbought when above 70 and oversold when below 30. These traditional
levels can also be adjusted to better fit the security or analytical requirements. Raising
overbought to 80 or lowering oversold to 20 will reduce the number of overbought/oversold
readings. Short-term traders sometimes use 2-period RSI to look for overbought readings above
80 and oversold readings below 20.
Calculation
For each trading period an upward change U or downward change D is calculated. Up periods
are characterized by the close being higher than the previous close:
U = closenow − closeprevious
D=0
Conversely, a down period is characterized by the close being lower than the previous period's
(note that D is nonetheless a positive number),
U=0
D = closeprevious − closenow
If the last close is the same as the previous, both U and D are zero. The average U and D are
calculated using an n-period exponential moving average (EMA). The ratio of these averages is
the Relative Strength:
If the average of D values is zero, then the RSI value is defined as 100.
The Relative Strength is then converted to a Relative Strength Index between 0 and 100:

The exponential moving averages should be appropriately initialized with a simple averages
using the first n values in the price series.
[edit] Interpretation
This section does not cite any references or sources.
Please help improve this section by adding citations to reliable sources. Unsourced material may be
challenged and removed. (September 2009)

[edit] Basic configuration

Relative Strength Index 14-period

The RSI is presented on a graph above or below the price chart. The indicator has an upper line,
typically at 70, a lower line at 30, and a dashed mid-line at 50. Wilder recommended a
smoothing period of 14 (see EMA smoothing, i.e. α = 1/14 or N = 27).
[edit] Principles
Wilder posited that when price moves up very rapidly, at some point it is considered overbought.
Likewise, when price falls very rapidly, at some point it is considered oversold. In either case,
Wilder deemed a reaction or reversal imminent.
The level of the RSI is a measure of the stock's recent trading strength. The slope of the RSI is
directly proportional to the velocity of a change in the trend. The distance traveled by the RSI is
proportional to the magnitude of the move.
Wilder believed that tops and bottoms are indicated when RSI goes above 70 or drops below 30.
Traditionally, RSI readings greater than the 70 level are considered to be in overbought territory,
and RSI readings lower than the 30 level are considered to be in oversold territory. In between
the 30 and 70 level is considered neutral, with the 50 level a sign of no trend.
[edit] Divergence
Wilder further believed that divergence between RSI and price action is a very strong indication
that a market turning point is imminent. Bearish divergence occurs when price makes a new high
but the RSI makes a lower high, thus failing to confirm. Bullish divergence occurs when price
makes a new low but RSI makes a higher low.
[edit] Overbought and oversold conditions
Wilder thought that "failure swings" above 70 and below 30 on the RSI are strong indications of
market reversals. For example, assume the RSI hits 76, pulls back to 72, then rises to 77. If it
falls below 72, Wilder would consider this a "failure swing" above 70.
Finally, Wilder wrote that chart formations and areas of support and resistance could sometimes
be more easily seen on the RSI chart as opposed to the price chart. The center line for the relative
strength index is 50, which is often seen as both the support and resistance line for the indicator.
If the relative strength index is below 50, it generally means that the stock's losses are greater
than the gains. When the relative strength index is above 50, it generally means that the gains are
greater than the losses.
[edit] Uptrends and downtrends
In addition to Wilder's original theories of RSI interpretation, Andrew Cardwell has developed
several new interpretations of RSI to help determine and confirm trend. First, Cardwell noticed
that uptrends generally traded between RSI 40 and 80, while downtrends usually traded between
RSI 60 and 20. Cardwell observed when securities change from uptrend to downtrend and vice
versa, the RSI will undergo a "range shift."

Example of RSI Indicator Divergence

Next, Cardwell noted that bearish divergence: 1) only occurs in uptrends, and 2) mostly only
leads to a brief correction instead of a reversal in trend. Therefore bearish divergence is a sign
confirming an uptrend. Similarly, bullish divergence is a sign confirming a downtrend.
[edit] Reversals
Finally, Cardwell discovered the existence of positive and negative reversals in the RSI.
Reversals are the opposite of divergence. For example, a positive reversal occurs when an
uptrend price correction results in a higher low compared to the last price correction, while RSI
results in a lower low compared to the prior correction. A negative reversal happens when a
downtrend rally results in a lower high compared to the last downtrend rally, but RSI makes a
higher high compared to the prior rally.
In other words, despite stronger momentum as seen by the higher high or lower low in the RSI,
price could not make a higher high or lower low. This is evidence the main trend is about to
resume. Cardwell noted that positive reversals only happen in uptrends while negative reversals
only occur in downtrends, and therefore their existence confirms the trend.
[edit] Cutler's RSI
A variation called Cutler's RSI is based on a simple moving average of U and D,[2] instead of the
exponential average above. Cutler had found that since Wilder used an exponential moving
average to calculate RSI, the value of Wilder's RSI depended upon where in the data file his
calculations started. Cutler termed this Data Length Dependency. Cutler's RSI is not data length
dependent, and returns consistent results regardless of the length of, or the starting point within a
data file.

Relative Strength Index - RSI

What Does Relative Strength Index - RSI Mean?

A technical momentum indicator that compares the magnitude of recent gains to recent losses in
an attempt to determine overbought and oversold conditions of an asset. It is calculated using the
following formula:
RSI = 100 - 100/(1 + RS*)
*Where RS = Average of x days' up closes / Average of x days' down closes.
As you can see from the chart, the RSI ranges from 0 to 100. An asset is deemed to be
overbought once the RSI approaches the 70 level, meaning that it may be getting overvalued and
is a good candidate for a pullback. Likewise, if the RSI approaches 30, it is an indication that the
asset may be getting oversold and therefore likely to become undervalued.

Investopedia explains Relative Strength Index - RSI

A trader using RSI should be aware that large surges and drops in the price of an asset will affect
the RSI by creating false buy or sell signals. The RSI is best used as a valuable complement to
other stock-picking tools.

Key Characteristics of Hedge Funds

• Hedge funds utilize a variety of financial instruments to reduce risk, enhance returns and minimize the
correlation with equity and bond markets. Many hedge funds are flexible in their investment options (can use
short selling, leverage, derivatives such as puts, calls, options, futures, etc).
• Hedge funds vary enormously in terms of investment returns, volatility and risk. Many, but not all, hedge
fund strategies tend to hedge against downturns in the markets being traded.
• Some hedge fund strategies have the ability to deliver non-market correlated returns. It is important to
understand the strategy being employed, before investing.
• Many hedge funds have as an objective consistency of returns and capital preservation rather than
magnitude of returns. They have learned this is the best way to attract large capital inflows and retain
investors.
• Most hedge funds are managed by experienced investment professionals who are generally disciplined and
 diligent.
• Pension funds, endowments, insurance companies, private banks and high net worth individuals and
families invest in hedge funds to minimize overall portfolio volatility and enhance returns.
• Most hedge fund managers are highly specialized and trade only within their area of expertise and
competitive advantage.
• Hedge funds heavily weight managers’ remuneration towards performance incentives, thus attract the best
talent in the investment business. Unfortunately, this can also lead to undue risks being taken. It is important
to verify that managers have their own money invested in their fund.

Commodity risk
Commodity risk refers to the uncertainties of future market values and of the size of the future
income, caused by the fluctuation in the prices of commodities.[1] These commodities may be
grains, metals, gas, electricity etc. A commodity enterprise needs to deal with the following
kinds of risks:
• Price risk (Risk arising out of adverse movements in the world prices, exchange rates,
basis between local and world prices)
• Quantity risk
• Cost risk (Input price risk)
• Political risk
[edit] Groups at Risk
There are broadly four categories of agents who face the commodities risk:
• Producers (farmers, plantation companies, and mining companies) face price risk, cost
risk (on the prices of their inputs) and quantity risk
• Buyers (cooperatives, commercial traders and trait ants) face price risk between the time
of up-country purchase buying and sale, typically at the port, to an exporter.
• Exporters face the same risk between purchase at the port and sale in the destination
market; and may also face political risks with regard to export licenses or foreign
exchange conversion.
• Governments face price and quantity risk with regard to tax revenues, particularly where
tax rates rise as commodity prices rise (generally the case with metals and energy
exports) or if support or other payments depend on the level of commodity prices.

Currency risk arises from exchange rate moves between pairs of currencies. If you
have investments or assets in a foreign country with a different currency, you face currency risk,
unless the foreign currency is pegged to your domestic currency or your exposure is hedged.
A simple example shows how currency risk affects your returns.
Let’s suppose you’re an American investor and you put $10,000 into a European stock market
tracker.
Your investment is not hedged, and so you’re exposed to changes in the exchange rate between
the dollar and the euro. That is, you’re exposed to currency risk.
Suppose over 12 months the European market and therefore your tracker goes up 20% in local
euro terms:
 • If the dollar and the euro is at the same exchange rate after 12 months as when you made
your investment, your holding is now worth $12,000. (i.e. $10,000 increased by 20%).
• Say the dollar appreciated by 25% versus the euro over 12 months. Your holding would
be worth $9,600 (12,000 / 1.25). i.e. Your euro position now buys fewer dollars.
• Say the dollar depreciated by 25% versus the euro over 12 months. Your holding would
be worth $16,000 (12,000 / 0.75). i.e. Your euro position now buys more dollars.
As you can see, currency risk can dramatically affect your returns, ranging from magnifying
your gains to turning gains into losses in your own currency. The basic rule is:
• When the foreign currency strengthens versus your own currency, your overall return
goes up
• When the foreign currency weakens versus your own currency, your overall return goes
down

Interest rate risk

From Wikipedia, the free encyclopedia
Categories of
financial risk
Credit risk
Concentration risk
Market risk
Interest rate risk
Currency risk
Equity risk
Commodity risk
Liquidity risk
Refinancing risk
Operational risk
Legal risk
Political risk
Reputational risk
Volatility risk
Settlement risk
Profit risk
Systemic risk
v·d·e
Interest rate risk is the risk (variability in value) borne by an interest-bearing asset, such as a
loan or a bond, due to variability of interest rates. In general, as rates rise, the price of a fixed rate
bond will fall, and vice versa. Interest rate risk is commonly measured by the bond's duration.
Asset liability management is a common name for the complete set of techniques used to manage
risk within a general enterprise risk management framework.

Contents
[hide]

Calculating interest rate risk

Interest rate risk analysis is almost always based on simulating movements in one or more yield
curves using the Heath-Jarrow-Morton framework to ensure that the yield curve movements are
both consistent with current market yield curves and such that no riskless arbitrage is possible.
The Heath-Jarrow-Morton framework was developed in the early 1990s by David Heath of
Cornell University, Andrew Morton of Lehman Brothers, and Robert A. Jarrow of Kamakura
Corporation and Cornell University.
There are a number of standard calculations for measuring the impact of changing interest rates
on a portfolio consisting of various assets and liabilities. The most common techniques include:
1. Marking to market, calculating the net market value of the assets and liabilities,
sometimes called the "market value of portfolio equity"
2. Stress testing this market value by shifting the yield curve in a specific way. Duration is a
stress test where the yield curve shift is parallel
3. Calculating the Value at Risk of the portfolio
4. Calculating the multiperiod cash flow or financial accrual income and expense for N
periods forward in a deterministic set of future yield curves
5. Doing step 4 with random yield curve movements and measuring the probability
distribution of cash flows and financial accrual income over time.
6. Measuring the mismatch of the interest sensitivity gap of assets and liabilities, by
classifying each asset and liability by the timing of interest rate reset or maturity,
whichever comes first.
[edit] Banks and interest rate risk
Banks face four types of interest rate risk:
Basis risk
The risk presented when yields on assets and costs on liabilities are based on different
bases, such as the London Interbank Offered Rate (LIBOR) versus the U.S. prime rate. In
some circumstances different bases will move at different rates or in different directions,
which can cause erratic changes in revenues and expenses.
Yield curve risk
The risk presented by differences between short-term and long-term interest rates. Short-
term rates are normally lower than long-term rates, and banks earn profits by borrowing
short-term money (at lower rates) and investing in long-term assets (at higher rates). But
the relationship between short-term and long-term rates can shift quickly and
dramatically, which can cause erratic changes in revenues and expenses.
Repricing risk
The risk presented by assets and liabilities that reprice at different times and rates. For
instance, a loan with a variable rate will generate more interest income when rates rise
and less interest income when rates fall. If the loan is funded with fixed rated deposits,
the bank's interest margin will fluctuate.
Option risk
It is presented by optionality that is embedded in some assets and liabilities. For instance,
mortgage loans present significant option risk due to prepayment speeds that change
 dramatically when interest rates rise and fall. Falling interest rates will cause many
borrowers to refinance and repay their loans, leaving the bank with uninvested cash when
interest rates have declined. Alternately, rising interest rates cause mortgage borrowers to
repay slower, leaving the bank with more loans based on prior, lower interest rates.
Option risk is difficult to measure and control.
Most banks are asset sensitive, meaning interest rate changes impact asset yields more than they
impact liability costs. This is because substantial amounts of bank funding are not affected, or
are just minimally affected, by changes in interest rates. The average checking account pays no
interest, or very little interest, so changes in interest rates do not produce notable changes in
interest expense. However, banks have large concentrations of short-term and/or variable rate
loans, so changes in interest rates significantly impact interest income. In general, banks earn
more money when interest rates are high, and they earn less money when interest rates are low.
This relationship often breaks down in very large banks that rely significantly on funding sources
other than traditional bank deposits. Large banks are often liability sensitive because they depend
on large concentrations of funding that are highly interest rate sensitive. Large banks also tend to
maintain large concentrations of fixed rate loans, which further increases liability sensitivity.
Therefore, large banks will often earn more net interest income when interest rates are low.

Equity risk
Equity risk is the risk that one's investments will depreciate because of stock market dynamics
causing one to lose money.
The measure of risk used in the equity markets is typically the standard deviation of a security's
price over a number of periods. The standard deviation will delineate the normal fluctuations one
can expect in that particular security above and below the mean, or average. However, since
most investors would not consider fluctuations above the average return as "risk", some
economists prefer other means of measuring it.

Volatility risk
Volatility risk is the risk of a change of price of a portfolio as a result of changes in the volatility
of a risk factor. It usually applies to portfolios of derivatives instruments, where the volatility of
its underlyings is a major influencer of prices.
[edit] Sensitivity to Volatility
A measure for the sensitivity of a price of a portfolio (or asset) to changes in volatility is vega,
the rate of change of the value of the portfolio with respect to the volatility of the underlying asse

Credit risk is an investor's risk of loss arising from a borrower who does not make
payments as promised. Such an event is called a default. Another term for credit risk is default
risk.
Investor losses include lost principal and interest, decreased cash flow, and increased collection
costs, which arise in a number of circumstances:
• A consumer does not make a payment due on a mortgage loan, credit card, line of credit,
or other loan
 • A business does not make a payment due on a mortgage, credit card, line of credit, or
other loan
• A business or consumer does not pay a trade invoice when due
• A business does not pay an employee's earned wages when due
• A business or government bond issuer does not make a payment on a coupon or principal
payment when due
• An insolvent insurance company does not pay a policy obligation
• An insolvent bank won't return funds to a depositor
• A government grants bankruptcy protection to an insolvent consumer or business

• Portfolio Management
•
• What Does Portfolio Management Mean?
The art and science of making decisions about investment mix and policy, matching
investments to objectives, asset allocation for individuals and institutions, and balancing
risk against. performance.

Portfolio management is all about strengths, weaknesses, opportunities and threats in the
choice of debt vs. equity, domestic vs. international, growth vs. safety, and many other
tradeoffs encountered in the attempt to maximize return at a given appetite for risk.

•
• Investopedia explains Portfolio Management
In the case of mutual and exchange-traded funds (ETFs), there are two forms of portfolio
management: passive and active. Passive management simply tracks a market index,
commonly referred to as indexing or index investing. Active management involves a
single manager, co-managers, or a team of managers who attempt to beat the market
return by actively managing a fund's portfolio through investment decisions based on
research and decisions on individual holdings. Closed-end funds are generally actively
managed.

Portfolio management
From Wikipedia, the free encyclopedia
Portfolio Management may refer to:
• Investment management, handled by a portfolio manager
• IT portfolio management
• Project management
• Project portfolio management

Diversification (finance)
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v·d·e

In finance, diversification means reducing risk by investing in a variety of

assets. If the asset values do not move up and down in perfect synchrony, a
diversified portfolio will have less risk than the weighted average risk of its
constituent assets, and often less risk than the least risky of its constituents.
[1]. Therefore, any risk-averse investor will diversify to at least some extent,
with more risk-averse investors diversifying more completely than less risk-
averse investors.

Diversification is one of two general techniques for reducing investment risk.

The other is hedging. Diversification relies on the lack of a tight positive
relationship among the assets' returns, and works even when correlations are
near zero or somewhat positive. Hedging relies on negative correlation
among assets, or shorting assets with positive correlation.

It is important to remember that diversification only works because

investment in each individual asset is reduced. If someone starts with
$10,000 in one stock and then puts $10,000 in another stock, they would
have more risk, not less. Diversification would require the sale of $5,000 of
the first stock to be put into the second. There would then be less risk.
Hedging, by contrast, reduces risk without selling any of the original
position[2].

The risk reduction from diversification does not mean anyone else has to take
more risk. If person A owns $10,000 of one stock and person B owns $10,000
of another, both A and B will reduce their risk if they exchange $5,000 of the
two stocks, so each now has a more diversified portfolio[3].
Diversification (finance)
From Wikipedia, the free encyclopedia

In finance, diversification means reducing risk by investing in a variety of assets. If the asset
values do not move up and down in perfect synchrony, a diversified portfolio will have less risk
than the weighted average risk of its constituent assets, and often less risk than the least risky of
its constituents.[1]. Therefore, any risk-averse investor will diversify to at least some extent, with
more risk-averse investors diversifying more completely than less risk-averse investors.
Diversification is one of two general techniques for reducing investment risk. The other is
hedging. Diversification relies on the lack of a tight positive relationship among the assets'
returns, and works even when correlations are near zero or somewhat positive. Hedging relies on
negative correlation among assets, or shorting assets with positive correlation.
It is important to remember that diversification only works because investment in each individual
asset is reduced. If someone starts with $10,000 in one stock and then puts $10,000 in another
stock, they would have more risk, not less. Diversification would require the sale of $5,000 of
the first stock to be put into the second. There would then be less risk. Hedging, by contrast,
reduces risk without selling any of the original position[2].
The risk reduction from diversification does not mean anyone else has to take more risk. If
person A owns $10,000 of one stock and person B owns $10,000 of another, both A and B will
reduce their risk if they exchange $5,000 of the two stocks, so each now has a more diversified
portfolio[3].

Capital Asset Pricing Model - CAPM

What Does Capital Asset Pricing Model - CAPM Mean?

A model that describes the relationship between risk and expected return and that is used in the
pricing of risky securities.

The general idea behind CAPM is that investors need to be compensated in two ways: time value
of money and risk. The time value of money is represented by the risk-free (rf) rate in the
formula and compensates the investors for placing money in any investment over a period of
time. The other half of the formula represents risk and calculates the amount of compensation the
investor needs for taking on additional risk. This is calculated by taking a risk measure
(beta) that compares the returns of the asset to the market over a period of time and to the market
premium (Rm-rf).

Investopedia explains Capital Asset Pricing Model - CAPM

The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free
security plus a risk premium. If this expected return does not meet or beat the required return,
then the investment should not be undertaken. The security market line plots the results of the
CAPM for all different risks (betas).

Using the CAPM model and the following assumptions, we can compute the expected return of a
stock in this CAPM example: if the risk-free rate is 3%, the beta (risk measure) of the stock is 2
and the expected market return over the period is 10%, the stock is expected to return 17% (3%
+2(10%-3%)).

Financial Concepts: Capital Asset Pricing Model (CAPM)

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Pronounced as though it were spelled "cap-m", this model was originally

developed in 1952 by Harry Markowitz and fine-tuned over a decade later by
others, including William Sharpe. The capital asset pricing model (CAPM)
describes the relationship between risk and expected return, and it serves as
a model for the pricing of risky securities.

CAPM says that the expected return of a security or a portfolio equals the
rate on a risk-free security plus a risk premium. If this expected return does
not meet or beat our required return, the investment should not be
undertaken.

The commonly used formula to describe the CAPM relationship is as follows:

Required (or expected) Return = RF Rate + (Market Return - RF Rate)*Beta

For example, let's say that the current risk free-rate is 5%, and the S&P 500
is expected to return to 12% next year. You are interested in determining the
return that Joe's Oyster Bar Inc (JOB) will have next year. You have
determined that its beta value is 1.9. The overall stock market has a beta of
1.0, so JOB's beta of 1.9 tells us that it carries more risk than the overall
market; this extra risk means that we should expect a higher potential return
than the 12% of the S&P 500. We can calculate this as the following:

Required (or expected) Return = 5% + (12% - 5%)*1.9

Required (or expected) Return = 18.3%

What CAPM tells us is that Joe's Oyster Bar has a required rate of return of
18.3%. So, if you invest in JOB, you should be getting at least 18.3% return on
your investment. If you don't think that JOB will produce those kinds of
returns for you, then you should consider investing in a different company.

It is important to remember that high-beta shares usually give the highest

returns. Over a long period of time, however, high beta shares are the worst
 performers during market declines (bear markets). While you might receive
high returns from high beta shares, there is no guarantee that the CAPM
return is realized.

Capital asset pricing model

From Wikipedia, the free encyclopedia

An estimation of the CAPM and the Security Market Line (purple) for the Dow Jones Industrial
Average over 3 years for monthly data.
In finance, the capital asset pricing model (CAPM) is used to determine a theoretically
appropriate required rate of return of an asset, if that asset is to be added to an already well-
diversified portfolio, given that asset's non-diversifiable risk. The model takes into account the
asset's sensitivity to non-diversifiable risk (also known as systematic risk or market risk), often
represented by the quantity beta (β) in the financial industry, as well as the expected return of the
market and the expected return of a theoretical risk-free asset.
The model was introduced by Jack Treynor (1961, 1962),[1] William Sharpe (1964), John Lintner
(1965a,b) and Jan Mossin (1966) independently, building on the earlier work of Harry
Markowitz on diversification and modern portfolio theory. Sharpe, Markowitz and Merton
Miller jointly received the Nobel Memorial Prize in Economics for this contribution to the field
of financial economics.
The formula
The Security Market Line, seen here in a graph, describes a relation between the beta and the
asset's expected rate of return.

The CAPM is a model for pricing an individual security or a portfolio. For individual securities,
we make use of the security market line (SML) and its relation to expected return and systematic
risk (beta) to show how the market must price individual securities in relation to their security
risk class. The SML enables us to calculate the reward-to-risk ratio for any security in relation to
that of the overall market. Therefore, when the expected rate of return for any security is deflated
by its beta coefficient, the reward-to-risk ratio for any individual security in the market is equal
to the market reward-to-risk ratio, thus:

The market reward-to-risk ratio is effectively the market risk premium and by rearranging the
above equation and solving for E(Ri), we obtain the Capital Asset Pricing Model (CAPM).

where:

• is the expected return on the capital asset

• is the risk-free rate of interest such as interest arising from government bonds

• (the beta) is the sensitivity of the expected excess asset returns to the expected excess

market returns, or also ,

• is the expected return of the market

 • is sometimes known as the market premium or risk premium (the
difference between the expected market rate of return and the risk-free rate of return).
Restated, in terms of risk premium, we find that:

which states that the individual risk premium equals the market premium times β.
Note 1: the expected market rate of return is usually estimated by measuring the Geometric
Average of the historical returns on a market portfolio (e.g. S&P 500).
Note 2: the risk free rate of return used for determining the risk premium is usually the arithmetic
average of historical risk free rates of return and not the current risk free rate of return.
For the full derivation see Modern portfolio theory.
[edit] Security market line
The SML essentially graphs the results from the capital asset pricing model (CAPM) formula.
The x-axis represents the risk (beta), and the y-axis represents the expected return. The market
risk premium is determined from the slope of the SML.
The relationship between β and required return is plotted on the securities market line (SML)
which shows expected return as a function of β. The intercept is the nominal risk-free rate
available for the market, while the slope is the market premium, E(Rm)− Rf. The securities market
line can be regarded as representing a single-factor model of the asset price, where Beta is
exposure to changes in value of the Market. The equation of the SML is thus:

It is a useful tool in determining if an asset being considered for a portfolio offers a reasonable
expected return for risk. Individual securities are plotted on the SML graph. If the security's
expected return versus risk is plotted above the SML, it is undervalued since the investor can
expect a greater return for the inherent risk. And a security plotted below the SML is overvalued
since the investor would be accepting less return for the amount of risk assumed.
[edit] Asset pricing
Once the expected/required rate of return, E(Ri), is calculated using CAPM, we can compare this
required rate of return to the asset's estimated rate of return over a specific investment horizon to
determine whether it would be an appropriate investment. To make this comparison, you need an
independent estimate of the return outlook for the security based on either fundamental or
technical analysis techniques, including P/E, M/B etc.
Assuming that the CAPM is correct, an asset is correctly priced when its estimated price is the
same as the present value of future cash flows of the asset, discounted at the rate suggested by
CAPM. If the observed price is higher than the CAPM valuation, then the asset is overvalued
(and undervalued when the estimated price is below the CAPM valuation).[citation needed] When the
asset does not lie on the SML, this could also suggest mis-pricing. Since the expected return of
the asset at time t is , a higher expected return than what CAPM
suggests indicates that Pt is too low (the asset is currently undervalued), assuming that at time t +
1 the asset returns to the CAPM suggested price.[2]
[edit] Asset-specific required return
The CAPM returns the asset-appropriate required return or discount rate—i.e. the rate at which
future cash flows produced by the asset should be discounted given that asset's relative riskiness.
Betas exceeding one signify more than average "riskiness"; betas below one indicate lower than
average. Thus, a more risky stock will have a higher beta and will be discounted at a higher rate;
less sensitive stocks will have lower betas and be discounted at a lower rate. Given the accepted
concave utility function, the CAPM is consistent with intuition—investors (should) require a
higher return for holding a more risky asset.
Since beta reflects asset-specific sensitivity to non-diversifiable, i.e. market risk, the market as a
whole, by definition, has a beta of one. Stock market indices are frequently used as local proxies
for the market—and in that case (by definition) have a beta of one. An investor in a large,
diversified portfolio (such as a mutual fund), therefore, expects performance in line with the
market.
[edit] Risk and diversification
The risk of a portfolio comprises systematic risk, also known as undiversifiable risk, and
unsystematic risk which is also known as idiosyncratic risk or diversifiable risk. Systematic risk
refers to the risk common to all securities—i.e. market risk. Unsystematic risk is the risk
associated with individual assets. Unsystematic risk can be diversified away to smaller levels by
including a greater number of assets in the portfolio (specific risks "average out"). The same is
not possible for systematic risk within one market. Depending on the market, a portfolio of
approximately 30-40 securities in developed markets such as UK or US will render the portfolio
sufficiently diversified such that risk exposure is limited to systematic risk only. In developing
markets a larger number is required, due to the higher asset volatilities.
A rational investor should not take on any diversifiable risk, as only non-diversifiable risks are
rewarded within the scope of this model. Therefore, the required return on an asset, that is, the
return that compensates for risk taken, must be linked to its riskiness in a portfolio context - i.e.
its contribution to overall portfolio riskiness - as opposed to its "stand alone riskiness." In the
CAPM context, portfolio risk is represented by higher variance i.e. less predictability. In other
words the beta of the portfolio is the defining factor in rewarding the systematic exposure taken
by an investor.
[edit] The efficient frontier
Main article: Modern portfolio theory#The efficient frontier with no risk-free asset
The (Markowitz) efficient frontier. CAL stands for the capital allocation line.
The CAPM assumes that the risk-return profile of a portfolio can be optimized—an optimal
portfolio displays the lowest possible level of risk for its level of return. Additionally, since each
additional asset introduced into a portfolio further diversifies the portfolio, the optimal portfolio
must comprise every asset, (assuming no trading costs) with each asset value-weighted to
achieve the above (assuming that any asset is infinitely divisible). All such optimal portfolios,
i.e., one for each level of return, comprise the efficient frontier.
Because the unsystematic risk is diversifiable, the total risk of a portfolio can be viewed as beta.
[edit] The market portfolio
An investor might choose to invest a proportion of his or her wealth in a portfolio of risky assets
with the remainder in cash—earning interest at the risk free rate (or indeed may borrow money to
fund his or her purchase of risky assets in which case there is a negative cash weighting). Here,
the ratio of risky assets to risk free asset does not determine overall return—this relationship is
clearly linear. It is thus possible to achieve a particular return in one of two ways:
1. By investing all of one's wealth in a risky portfolio,
2. or by investing a proportion in a risky portfolio and the remainder in cash (either
borrowed or invested).
For a given level of return, however, only one of these portfolios will be optimal (in the sense of
lowest risk). Since the risk free asset is, by definition, uncorrelated with any other asset, option 2
will generally have the lower variance and hence be the more efficient of the two.
This relationship also holds for portfolios along the efficient frontier: a higher return portfolio
plus cash is more efficient than a lower return portfolio alone for that lower level of return. For a
given risk free rate, there is only one optimal portfolio which can be combined with cash to
achieve the lowest level of risk for any possible return. This is the market portfolio.
[edit] Assumptions of CAPM
This section does not cite any references or sources.
Please help improve this section by adding citations to reliable sources. Unsourced material may be
challenged and removed. (July 2010)

All investors:
 1. Aim to maximize economic utilities.
2. Are rational and risk-averse.
3. Are broadly diversified across a range of investments.
4. Are price takers, i.e., they cannot influence prices.
5. Can lend and borrow unlimited amounts under the risk free rate of interest.
6. Trade without transaction or taxation costs.
7. Deal with securities that are all highly divisible into small parcels.
8. Assume all information is available at the same time to all investors.
[edit] Shortcomings of CAPM
• The model assumes that either asset returns are (jointly) normally distributed random
variables or that investors employ a quadratic form of utility. It is however frequently
observed that returns in equity and other markets are not normally distributed. As a result,
large swings (3 to 6 standard deviations from the mean) occur in the market more
frequently than the normal distribution assumption would expect.[3]
• The model assumes that the variance of returns is an adequate measurement of risk. This
might be justified under the assumption of normally distributed returns, but for general
return distributions other risk measures (like coherent risk measures) will likely reflect
the investors' preferences more adequately. Indeed risk in financial investments is not
variance in itself, rather it is the probability of losing: it is asymmetric in nature.
• The model assumes that all investors have access to the same information and agree
about the risk and expected return of all assets (homogeneous expectations assumption).
[citation needed]

• The model assumes that the probability beliefs of investors match the true distribution of
returns. A different possibility is that investors' expectations are biased, causing market
prices to be informationally inefficient. This possibility is studied in the field of
behavioral finance, which uses psychological assumptions to provide alternatives to the
CAPM such as the overconfidence-based asset pricing model of Kent Daniel, David
Hirshleifer, and Avanidhar Subrahmanyam (2001).[4]
• The model does not appear to adequately explain the variation in stock returns. Empirical
studies show that low beta stocks may offer higher returns than the model would predict.
Some data to this effect was presented as early as a 1969 conference in Buffalo, New
York in a paper by Fischer Black, Michael Jensen, and Myron Scholes. Either that fact is
itself rational (which saves the efficient-market hypothesis but makes CAPM wrong), or
it is irrational (which saves CAPM, but makes the EMH wrong – indeed, this possibility
makes volatility arbitrage a strategy for reliably beating the market).[citation needed]
• The model assumes that given a certain expected return investors will prefer lower risk
(lower variance) to higher risk and conversely given a certain level of risk will prefer
higher returns to lower ones. It does not allow for investors who will accept lower returns
for higher risk. Casino gamblers clearly pay for risk, and it is possible that some stock
traders will pay for risk as well.[citation needed]
• The model assumes that there are no taxes or transaction costs, although this assumption
may be relaxed with more complicated versions of the model.[citation needed]
 • The market portfolio consists of all assets in all markets, where each asset is weighted by
its market capitalization. This assumes no preference between markets and assets for
individual investors, and that investors choose assets solely as a function of their risk-
return profile. It also assumes that all assets are infinitely divisible as to the amount
which may be held or transacted.[citation needed]
• The market portfolio should in theory include all types of assets that are held by anyone
as an investment (including works of art, real estate, human capital...) In practice, such a
market portfolio is unobservable and people usually substitute a stock index as a proxy
for the true market portfolio. Unfortunately, it has been shown that this substitution is not
innocuous and can lead to false inferences as to the validity of the CAPM, and it has been
said that due to the inobservability of the true market portfolio, the CAPM might not be
empirically testable. This was presented in greater depth in a paper by Richard Roll in
1977, and is generally referred to as Roll's critique.[5]
• The model assumes just two dates, so that there is no opportunity to consume and
rebalance portfolios repeatedly over time. The basic insights of the model are extended
and generalized in the intertemporal CAPM (ICAPM) of Robert Merton, and the
consumption CAPM (CCAPM) of Douglas Breeden and Mark Rubinstein.[citation needed]
• CAPM assumes that all investors will consider all of their assets and optimize one
portfolio. This is in sharp contradiction with portfolios that are held by individual
investors: humans tend to have fragmented portfolios or, rather, multiple portfolios: for
each goal one portfolio — see behavioral portfolio theory [6] and Maslowian Portfolio
Theory.[7]
[edit] See also

The capital market line (CML) is a line used in the capital asset pricing model
to illustrate the rates of return for efficient portfolios depending on the risk-free rate of return and
the level of risk (standard deviation) for a particular portfolio.

The CML is derived by drawing a tangent line from the intercept point on the efficient frontier to
the point where the expected return equals the risk-free rate of return.

The CML is considered to be superior to the efficient frontier since it takes into account the
inclusion of a risk-free asset in the portfolio. The capital asset pricing model (CAPM)
demonstrates that the market portfolio is essentially the efficient frontier. This is achieved
visually through the security market line (SML).

The security market line is a line that graphs the systematic, or market, risk versus return of the
whole market at a certain time and shows all risky marketable securities.

The SML essentially graphs the results from the capital asset pricing model (CAPM) formula.
The x-axis represents the risk (beta), and the y-axis represents the expected return. The market
risk premium is determined from the slope of the SML.

The security market line is a useful tool in determining whether an asset being considered for a
portfolio offers a reasonable expected return for risk. Individual securities are plotted on the
SML graph. If the security's risk versus expected return is plotted above the SML, it is
undervalued because the investor can expect a greater return for the inherent risk. A security
plotted below the SML is overvalued because the investor would be accepting less return for the
amount of risk assumed.

Read more:
http://wiki.answers.com/Q/How_does_capital_market_line_differ_from_security_market_line#ix
zz1N3HDpy7J
The capital market (securities markets) is the market for securities, where
companies and the government can raise long-term funds. The capital market
includes the stock market and the bond market. Financial regulators, such as the
U.S. Securities and Exchange Commission and the Financial Services Authority in
the UK, oversee the markets, to ensure that investors are protected against
misselling. The capital markets consist of the primary market, where new issues are
distributed to investors, and the secondary market, where existing securities are
traded.
The capital market can be contrasted with other financial markets such as the
money market which deals in short term liquid assets, and derivatives markets
which deals in derivative contracts.
Both the private and the public sectors provide market makers in the capital
markets.

While security market line is the linear relationship between the expected return of
seurity and its systematic risk, the expected return comparing a risk-free return
plus a risk premium.

Modern portfolio theory

From Wikipedia, the free encyclopedia
Portfolio analysis redirects here. For theorems about the mean-variance efficient
frontier, see Mutual fund separation theorem. For non-mean-variance portfolio analysis,
see Marginal conditional stochastic dominance.

Modern portfolio theory (MPT) is a theory of investment which

attempts to maximize portfolio expected return for a given amount of portfolio risk, or
equivalently minimize risk for a given level of expected return, by carefully choosing the
proportions of various assets. Although MPT is widely used in practice in the financial industry
and several of its creators won a Nobel memorial prize[1] for the theory, in recent years the basic
assumptions of MPT have been widely challenged by fields such as behavioral economics.
MPT is a mathematical formulation of the concept of diversification in investing, with the aim of
selecting a collection of investment assets that has collectively lower risk than any individual
asset. That this is possible can be seen intuitively because different types of assets often change
in value in opposite ways. For example, as prices in the stock market tend to move independently
from prices in the bond market, a collection of both types of assets can therefore have lower
overall risk than either individually. But diversification lowers risk even if assets' returns are not
negatively correlated—indeed, even if they are positively correlated.
More technically, MPT models an asset's return as a normally distributed function (or more
generally as an elliptically distributed random variable), defines risk as the standard deviation of
return, and models a portfolio as a weighted combination of assets so that the return of a
portfolio is the weighted combination of the assets' returns. By combining different assets whose
returns are not perfectly positively correlated, MPT seeks to reduce the total variance of the
portfolio return. MPT also assumes that investors are rational and markets are efficient.
MPT was developed in the 1950s through the early 1970s and was considered an important
advance in the mathematical modeling of finance. Since then, many theoretical and practical
criticisms have been leveled against it. These include the fact that financial returns do not follow
a Gaussian distribution or indeed any symmetric distribution, and that correlations between asset
classes are not fixed but can vary depending on external events (especially in crises). Further,
there is growing evidence that investors are not rational and markets are not efficient.[2][3]

Criticism
Despite its theoretical importance, critics of MPT question whether it is an ideal investing
strategy, because its model of financial markets does not match the real world in many ways.
[edit] Assumptions
The framework of MPT makes many assumptions about investors and markets. Some are explicit
in the equations, such as the use of Normal distributions to model returns. Others are implicit,
such as the neglect of taxes and transaction fees. None of these assumptions are entirely true, and
each of them compromises MPT to some degree.
• Asset returns are (jointly) normally distributed random variables. In fact, it is
frequently observed that returns in equity and other markets are not normally distributed.
Large swings (3 to 6 standard deviations from the mean) occur in the market far more
frequently than the normal distribution assumption would predict.[8] While the model can
also be justified by assuming any return distribution which is jointly elliptical,[9][10] all the
joint elliptical distributions are symmetrical whereas asset returns empirically are not.
• Correlations between assets are fixed and constant forever. Correlations depend on
systemic relationships between the underlying assets, and change when these
relationships change. Examples include one country declaring war on another, or a
general market crash. During times of financial crisis all assets tend to become positively
correlated, because they all move (down) together. In other words, MPT breaks down
precisely when investors are most in need of protection from risk.
• All investors aim to maximize economic utility (in other words, to make as much
money as possible, regardless of any other considerations). This is a key assumption
of the efficient market hypothesis, upon which MPT relies.
• All investors are rational and risk-averse. This is another assumption of the efficient
market hypothesis, but we now know from behavioral economics that market participants
are not rational. It does not allow for "herd behavior" or investors who will accept lower
returns for higher risk. Casino gamblers clearly pay for risk, and it is possible that some
stock traders will pay for risk as well.
 • All investors have access to the same information at the same time. This also comes
from the efficient market hypothesis. In fact, real markets contain information
asymmetry, insider trading, and those who are simply better informed than others.
• Investors have an accurate conception of possible returns, i.e., the probability beliefs
of investors match the true distribution of returns. A different possibility is that
investors' expectations are biased, causing market prices to be informationally inefficient.
This possibility is studied in the field of behavioral finance, which uses psychological
assumptions to provide alternatives to the CAPM such as the overconfidence-based asset
pricing model of Kent Daniel, David Hirshleifer, and Avanidhar Subrahmanyam (2001).
[11]

• There are no taxes or transaction costs. Real financial products are subject both to
taxes and transaction costs (such as broker fees), and taking these into account will alter
the composition of the optimum portfolio. These assumptions can be relaxed with more
complicated versions of the model.[citation needed]
• All investors are price takers, i.e., their actions do not influence prices. In reality,
sufficiently large sales or purchases of individual assets can shift market prices for that
asset and others (via cross-elasticity of demand.) An investor may not even be able to
assemble the theoretically optimal portfolio if the market moves too much while they are
buying the required securities.
• Any investor can lend and borrow an unlimited amount at the risk free rate of
interest. In reality, every investor has a credit limit.
• All securities can be divided into parcels of any size. In reality, fractional shares
usually cannot be bought or sold, and some assets have minimum orders sizes.
More complex versions of MPT can take into account a more sophisticated model of the world
(such as one with non-normal distributions and taxes) but all mathematical models of finance
still rely on many unrealistic premises.

Arbitrage pricing theory

From Wikipedia, the free encyclopedia
In finance, arbitrage pricing theory (APT) is a general theory of asset pricing, that has become
influential in the pricing of stocks.
APT holds that the expected return of a financial asset can be modeled as a linear function of
various macro-economic factors or theoretical market indices, where sensitivity to changes in
each factor is represented by a factor-specific beta coefficient. The model-derived rate of return
will then be used to price the asset correctly - the asset price should equal the expected end of
period price discounted at the rate implied by the model. If the price diverges, arbitrage should
bring it back into line.
The theory was initiated by the economist Stephen Ross in 1976.

Contents
[hide]
 • 1 The APT model
• 2 Arbitrage and the APT
○ 2.1 Arbitrage in expectations
○ 2.2 Arbitrage mechanics
• 3 Relationship with the capital asset pricing model (CAPM)
• 4 Using the APT
○ 4.1 Identifying the factors
○ 4.2 APT and asset management
• 5 See also
• 6 References
• 7 External links

[edit] The APT model

Risky asset returns are said to follow a factor structure if they can be expressed as:

where
• E(rj) is the jth asset's expected return,
• Fk is a systematic factor (assumed to have mean zero),
• bjk is the sensitivity of the jth asset to factor k, also called factor loading,
• and εj is the risky asset's idiosyncratic random shock with mean zero.
Idiosyncratic shocks are assumed to be uncorrelated across assets and uncorrelated with the
factors.
The APT states that if asset returns follow a factor structure then the following relation exists
between expected returns and the factor sensitivities:

where
• RPk is the risk premium of the factor,
• rf is the risk-free rate,
That is, the expected return of an asset j is a linear function of the assets sensitivities to the n
factors.
Note that there are some assumptions and requirements that have to be fulfilled for the latter to
be correct: There must be perfect competition in the market, and the total number of factors may
never surpass the total number of assets (in order to avoid the problem of matrix singularity),
[edit] Arbitrage and the APT
Arbitrage is the practice of taking advantage of a state of imbalance between two (or possibly
more) markets and thereby making a risk-free profit; see rational pricing.
[edit] Arbitrage in expectations
The capital asset pricing model and its extensions are based on specific assumptions on
investors’ asset demand. For example:
• Investors care only about mean return and variance.
• Investors hold only traded assets.
[edit] Arbitrage mechanics
In the APT context, arbitrage consists of trading in two assets – with at least one being
mispriced. The arbitrageur sells the asset which is relatively too expensive and uses the proceeds
to buy one which is relatively too cheap.
Under the APT, an asset is mispriced if its current price diverges from the price predicted by the
model. The asset price today should equal the sum of all future cash flows discounted at the APT
rate, where the expected return of the asset is a linear function of various factors, and sensitivity
to changes in each factor is represented by a factor-specific beta coefficient.
A correctly priced asset here may be in fact a synthetic asset - a portfolio consisting of other
correctly priced assets. This portfolio has the same exposure to each of the macroeconomic
factors as the mispriced asset. The arbitrageur creates the portfolio by identifying x correctly
priced assets (one per factor plus one) and then weighting the assets such that portfolio beta per
factor is the same as for the mispriced asset.
When the investor is long the asset and short the portfolio (or vice versa) he has created a
position which has a positive expected return (the difference between asset return and portfolio
return) and which has a net-zero exposure to any macroeconomic factor and is therefore risk free
(other than for firm specific risk). The arbitrageur is thus in a position to make a risk-free profit: