Security Analysis for CS Executive Paper 4

What this chapter covers

Security Analysis: topics in the order to study them

1. 1Security Analysis: Meaning and ApproachesIt gives you the vocabulary and the fundamental versus technical split that the rest of the chapter builds on.
2. 2Risk and Return of SecuritiesYou need expected return, variance and standard deviation before you can value securities or build portfolios.
3. 3Valuation of Bonds and DebenturesBond valuation is the simplest discounting exercise, with fixed cash flows, so it is the best place to start numericals.
4. 4Valuation of Equity SharesIt extends discounting to uncertain dividends, using the dividend discount and growth models, and relies on the bond method.
5. 5Technical Analysis and Dow TheoryThis is mostly theory, so it gives a break from numericals and completes the second approach introduced at the start.
6. 6Efficient Market HypothesisIt tests whether either approach can beat the market, which makes sense only after you know both.
7. 7Portfolio Theory and CAPMIt uses risk and return from earlier and ends the chapter by linking risk to required return.

How to prepare Security Analysis

1. Read the meaning and approaches first, and write a one-page comparison of fundamental and technical analysis.
2. Learn the risk and return measures, then work through expected return and standard deviation sums until you can do them without looking at the formula.
3. Practise bond valuation by listing the cash flows, discounting each one, and adding them. Do this for bonds with interest, zero-coupon bonds and redeemable bonds.
4. Practise equity valuation with the constant growth model and multi-stage dividend cases. Always check that the required return is higher than the growth rate before you apply the constant growth formula.
5. Make short notes for Dow Theory and the three forms of market efficiency, each with a definition and what it implies for investors.
6. Solve CAPM and portfolio return and risk problems, and write the formula, the substitution and the final conclusion in each answer.
7. Finish with timed past-paper questions and write full answers as you would in the exam.

Common mistakes in Security Analysis

• Using D₀ instead of D₁ in the constant growth model.

  Fix: Check whether the dividend given is the last one paid or the next expected one. If it is the last paid, multiply by (1 + g) first.

• Applying the growth formula when growth is higher than or equal to the required return.

  Fix: Write k > g as a check before every use. If it fails, the model does not apply and you should say so.

• Discounting bond cash flows at the coupon rate instead of the required return.

  Fix: Coupon rate sets the interest amount. The market yield or required return is the discount rate.

• Confusing the three forms of market efficiency.

  Fix: Remember it as nested: weak covers past prices, semi-strong adds public information, strong adds private information.

• Mixing up total risk and systematic risk in CAPM answers.

  Fix: Use standard deviation for total risk and beta for market risk. CAPM uses beta only.

• Writing only the final number in numericals.

  Fix: Write the formula, substitution, calculation and a one-line conclusion, such as whether the security is overvalued or undervalued.

Last-day revision: Security Analysis

• ✓Fundamental analysis studies economy, industry and company; technical analysis studies price and volume.
• ✓Expected return = Σ (probability × return).
• ✓Standard deviation is the square root of variance, and it measures total risk.
• ✓Bond value = present value of interest payments + present value of redemption value, discounted at the required return.
• ✓Zero-coupon bond value = redemption value ÷ (1 + r)ⁿ.
• ✓Constant growth model: P₀ = D₁ ÷ (k − g), valid only when k > g.
• ✓D₁ = D₀ × (1 + g).
• ✓Dow Theory describes primary, secondary and minor trends in the market.
• ✓Weak form efficiency says past prices cannot predict future prices; semi-strong adds public information; strong adds all information including private.
• ✓CAPM: Expected return = Rf + β × (Rm − Rf).
• ✓Beta measures systematic risk, which diversification cannot remove.
• ✓Diversification reduces unsystematic risk only.

Security Analysis practice questions

• Which belief is central to technical analysis?
• In the Gordon (constant growth) model, the intrinsic value of an equity share today is the expected dividend of the next year divided by whi…
• Shares of Kaveri Textiles Ltd. are traded in a market that is semi-strong form efficient. The company announces a surprisingly high annual p…
• A portfolio has 60% invested in Share X (expected return 15%) and 40% in Share Y (expected return 10%). The two shares have perfectly negati…
• Bharat Infra issues a 3-year debenture of face value ₹1,000 with a 10% annual coupon, redeemable at par at the end of year 3. If the require…
• A perpetual debenture pays an annual interest of ₹80. Investors require a return of 10%. If the required return rises to 16%, by what amount…
• An analyst estimates the intrinsic value of Kaveri Ltd's share at ₹480 using fundamental analysis. The current market price is ₹400. Which c…
• A bond with face value ₹1,000 and 12% annual coupon trades at ₹1,000 when the required return is 12%. Which statement is correct if the requ…

Security Analysis in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

• CMA FinalFundamental Analysis and Technical Analysis
• CA FinalSecurity Analysis
• FRM Part IIFactors
• CMA IntermediateRisk and Return