Portfolio & Capital Markets

8/7/2019 Portfolio & Capital Markets

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Portfolio And Capital Markets

Jeet R.Shah

M.Com , CFP CM

Veer ConsultancyServices Jeet R .Shah 2

Overview

Meaning :-1. Investment

2. Portfolio

3. Capital Market

Investment Attributes

Approaches to Investment DecisionMaking


Investment

Rarely ,Income = Expenses.

Income > Expenses = Savings

Income < Expenses = Borrowings

The tradeoff ofpresentconsumption for a higherlevel offutureconsumption is the reason forsaving.What you do with the savings to make themincrease over a time is Investment.

Thus it is the purchase of any asset with the

potential to yield future financial benefit to thepurchaser.


Two Key Aspects

1. Time .

2. Risk. Sacrifice takes place now and is certain .

The benefit is expected in the future and isuncertain.

In some investment Time element is dominant Govt Bonds.

In some investment Risk element is dominant

Stock Options. In some investment both Time and Risk are

dominant Equity Shares.


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Two concepts

1. Economic Investment :

Addition to the Capital Stock of the society.

Capital Stock of the society are the goods whichare used in the production of other goods.

2. Financial Investment :

This is an allocation of monetary resources tothe assets that are expected to yield some gain orreturn over a period of time.

It means an exchange of financial claims such asshares.


Portfolio

A portable case for holding paper,Drawings,etc

All the investments of an individual


Financial Market

A Financial Market is a market for thecreation and exchange of financial assets.

Functions :-

1. Facilitates Price Discovery

2. Provides Liquidity

3. Reduces cost of transacting.


Classification

Nature Of claim a. Debt Market

b. Equity Market

Maturity Of Claim a. Money Market

b.Capital Market

Seasoning Of Claim a. Primary Market

b. Secondary Market


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Classification contd.

Timing of Delivery a. Cash / Spot Market

b. Forward or Futures

Organisational Structure a. Exchange Traded

b. Over the Counter


Investment Attributes

1. Rate Of Return

2. Risk

3. Marketability

4. Tax Shelter

5. Convenience


Evaluation Of Various Investment AvenuesReturn Risk Marketa

bility /Liquidity

TaxShelter

Convenience

CurrentYield

CapitalAppreciati

on

EquityShares

Low High High FairlyHigh

High High

Non-convertibleDebentures

High Negligible Low Average Nil High

EquitySchemes

Low High High High High Very High

DebtSchemes

Moderate Low Low High No tax onDividends

Very High


Return Risk Marketa

bility /Liquidity

Tax

Shelter

Conveni

ence

CurrentYield

CapitalAppreciati

on

BankDeposits

Moderate Nil Negligible High Nil Very High

PPF Nil Moderate Nil Average Sec 80Cbenefit

Very High

LIP Nil Moderate Nil Average Sec 80Cbenefit

Very High

RealEstate

Moderate Moderate Negligi ble Low High Fair

Gold &Silver

Nil Moderate Average Average Nil Average

Evaluation Of Various Investment Avenues


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Approaches toInvestment Decision Making

Fundamental Approach

Psychological / Technical Approach

Academic Approach

Eclectic Approach

Cybernetic Analysis


Fundamental Approach

It is a method of forecasting the future pricemovements of a financial instrument basedon economic ,social , political and otherrelevant factors and the statistics that willaffect the basic supply and demand ofwhatever underlines the financial instrument.

It is an answer to the question of what to buyand why to buy.


Technical Approach

In his book Technical Analysis Explained , Martin Pingexplains :

The TA approach to investing

- is essentially a reflection of the idea that prices move intrends

-which are determined by the changing attitudes ofinvestors towards a variety of economic,monetary,political & psychological forces.

- The art of TA for it is an art is to identify trendchanges at an early stage &

-to maintain an investment posture until the weight of theevidence indicates that the trend has been reversed.


Academic Approach

Tenets

1. Market Price approx equals to IntrinsicValue

2. Stock price behaviour corresponds to arandom walk

3. There is a positive relationship between riskand return


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Eclectic Approach

Neither FA nor TA should be used in isolation.

It is better to use The Eclectic Approach.

This means-

Conduct FA to establish certain value anchors.

Do TA to assess the state of the market psychology .

Combine FA and TA to determine which securitiesare worth- buying, holding and disposing off.

Respect Market Price and do not show excessive zealin beating the market

Accept that for higher return there are higher risk.


Cybernetic Analysis

Jerry Felson offers an alternative to the efficientmarket theory in his book, Cybernetic Approachto Stock Market Analysis (Exposition Press, 1975)in order to bypass its perceived limitations anddeficiencies.

According to Felson, the extreme complexity ofthe stock market and the environment in which itoperates as well as inadequate investment toolshamper the investor from earning above-averageinvestment returns.


Cybernetic Analysis

Using cybernetics concepts (the science andcontrol of communication, and mathematicalanalysis of the flow of information) andartificial intelligence (advanced cybernetics)techniques, Felson proposes developingjudgmental decision-making processes byweighing evidence and formalizinginvestment analysis.


Cybernetic Analysis

In plain language, the cyberneticsapproach automates the investmentdecision-making process through theuse of pattern recognition, learningsystem theory, and other methods,removing the imperfect human factor

and theoretically improving investmentreturns.


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Cybernetic Analysis

Felson stresses that no investment analysiscan be very successful unless it conforms tothe law of requisite variety.

In other words, the investment decisionsystem must be as complex and as variableas the system (stock market) which it istrying to interpret.

According to Felson, this is where otherinvestment systems fail.

Risk And Return


Risk

Risk is the condition in which there is a possibility ofan adverse deviation from a desired outcome that isexpected or hoped for.

-Vaughan and Vaughan

Risk in holding securities is generally associated withpossibility that realized returns will be less than thereturns that were expected.

Thus in investment analysis it is variability of return.

The source of such disappointment is the failure of

dividends (interest) and/or the securitys price tomaterialize as expected.


Types of Risk

Total Risk =

Unique / unsystematic / Diversifiable risk

+

Market / systematic / Non- Diversifiablerisk


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Market / systematic / Non- Diversifiable risk

Some influences are external to the firm, cannot becontrolled, and affect large numbers of securities.

In investments, those forces that are uncontrollable,external and broad in their effect are called sourcesof systematic risk.

Systematic risk refers to that portion of totalvariability in return caused by factors affecting theprices of all securities.

Economic, political, and sociological changes aresources of systematic risk.


Market / systematic / Non- Diversifiable riskcontd.

Their effect is to cause prices of nearly all individualcommon stocks and/or all individual bonds to movetogether in the same manner.

It is measured by Beta.


Unique / unsystematic / Diversifiable risk

Some influences are internal to the firm and arecontrollable to a large degree.

Controllable internal factors somewhat peculiar toindustries and/or firms are refereed to as sources ofunsystematic risk.

Unsystematic risk is the portion of total risk that isunique to a firm or industry.


Unique / unsystematic / Diversifiable riskcontd.

Factors such as management capability, consumerpreferences, and labor strikes cause systematicvariability of returns in a firm..

Unsystematic factors are largely independent offactors affecting securities markets in general.

Because these factors affect one firm, they must beexamined for each firm


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Total risk


Sources of Systematic Risk

1.Market Risk

Finding stock prices falling from time to time while acompanys earnings are rising, and vice versa, is notuncommon.

The price of a stock may fluctuate widely within ashort span of time even though earnings remainunchanged.

The causes of this phenomenon are varied, but it ismainly due to a change in investors attitudes towardequities in general, or toward certain types or groupsof securities in particular.



Market Risk contd Variability in return on most common stocks that is

due to basic sweeping changes in investorsexpectations is referred to as market risk.

Market risk is caused by investor reaction to tangibleas well as intangible events.



2.Interest-Rate Risk

Interest-rate risk refers to the uncertainty of futuremarket values and of the size of future income,caused by fluctuations in the general level of interest

rates.


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3.Purchasing-Power Risk

Market risk and interest-rate risk can be defined interms of uncertainties as to the amount of currentdollars to be received by an investor.

Purchasing-power risk is the uncertainty of thepurchasing power of the amounts to be received.

In more everyday terms, purchasing-power riskrefers to the impact of inflation or deflation on aninvestment.


Sources of Unsystematic Risk

The uncertainty surroundings the ability of the issuerto make payments on securities stems from twosources:

(1) the operating environment of the business, and

(2) the financing of the firm.

These risks are referred to as business risk andfinancial risk, respectively.

They are strictly a function of the operatingconditions of the firm and the way in which itchooses to finance its operations.



1.Business Risk

Business risk is a function of the operating conditionsfaced by a firm and the variability these conditionsinject into operating income

Business risk can be divided into two broadcategories: external and internal.

Internal business risk is largely associated with the

efficiency with which a firm conducts its operationswith in the broader operating environment imposedupon it.



Each firm has its own set of internal risks, and thedegree to which it is successful in coping with them isreflected in operating efficiency.

To large extent, external business risk is the result ofoperating conditions imposes upon the firm bycircumstances beyond its control.

Each firm also faces its own set of externalrisks,depending upon the specific operating

environmental factors with which it must deal.


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2.Financial Risk

Financial risk is associated with the way in which acompany finances its activities.

We usually gauge financial risk by looking at thecapital structure of a firm.

The presence of borrowed money of debt in thecapital structure creates fixed payment in the form ofinterest that must be sustained by the firm.


Examples of risk

Systematic Risk

1. Interest rate Risk

2. Forex risk

3. Political Risk

4. Purchasing Power Risk

5. Sentiments

6. Other macro-economicrisk

Unsystematic Risk

1. Competition

2. Specific Law

3. Capital Structure

4. Product

5. Raw-materials

6. Manpower

7. Other internal firmspecific factors


Return

It is the primary motive behind investments.

It represents the reward for undertaking theinvestment.

Generally the investors who sacrifice their currentincome would like to be compensated for :

1. The time or period of sacrifice.

2. The expected rate of inflation.

3. The risk associated with the investment.


Measures of Return

1. Total Return (HPR) , R = C + P e----------------

P bC= cash payment received during the year.

P e = ending price

P b = Beginning price

2. HPY = HPR - 1


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Measures of Return contd.

Annual HPR = HPR1/n

Annual HPY ( CAGR )= Annual HPR -1


Real Rate Of Return

Return adjusted for inflation = 1+ Nominal Return

----------------------- - 1

1+Inflation Rate


Mean Historical Returns

Single Investment

1. Arithmetic Mean =

2. Geometric Mean =

nHPY /


Example of AM & GM

BEGINNING ENDING

YEAR VALUE VALUE HPR HPY

1 100.0 115.0 1.15 0.15

2 115.0 138.0 1.20 0.20

3 138.0 110.4 0.80 0.20


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Example of AM & GM contd

AM = [(0.15) + (0.20) + (0.20)]/3

= 0.15/3

= 0.05 = 5%

GM = [(1.15) (1.20) (0.80)]^1/3 1

= (1.104)^1/3 1

= 1.03353 1

= 0.03353 = 3.353%


GM V/S AM

Investors are typically concerned with long-termperformance when comparing alternativeinvestments.

GM is considered a superior measure of the long-term mean rate of return because it indicates thecompound annual rate of return based on the endingvalue of the investment versus its beginning value.

Specifically, using the prior example, if wecompounded 3.353 percent for three years,(1.03353)3, we would get an ending wealth value of1.104.


GM V/S AM contd.

Although the arithmetic average provides a goodindication of the expected rate of return for aninvestment during a future individual year, it isbiased upward if you are attempting to measure anassets long-term performance.

This is obvious for a volatile security.

Consider, for example, a security that increases inprice from Rs.50 to Rs. 100 during year 1 and drops

back to Rs. 50 during year 2.


GM V/S AM contd.

The annual HPYs would be:

BEGINNING ENDING

YEAR VALUE VALUE HPR HPY

1 50 100 2.00 1.00

2 100 50 0.50 0.50


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GM V/S AM contd.

This would give an AM rate of return of:

[(1.00) + (0.50)]/2 = .50/2

= 0.25 = 25%

This investment brought no change in wealth andtherefore no return, yet the AM rate of return iscomputed to be 25 percent.

The GM rate of return would be:

(2.00 0.50)^1/2 1 = (1.00)^1/2 1

= 1.00 1 = 0%

This answer of a 0 percent rate of return accuratelymeasures the fact that there was no change in

wealth from this investment over the two-yearperiod.


A Portfolio of Investments

The mean historical rate of return (HPY) for aportfolio of investments is measured as the weightedaverage of the HPY s for the individual investments inthe portfolio, or the overall change in value of theoriginal portfolio.

The weights used in computing the averages are therelative beginningmarket values for eachinvestment; this is referred to as dollar-weightedorvalue-weightedmean rate of return.


COMPUTATION OF HOLDING PERIOD YIELD FOR APORTFOLIO

0.0952,19,00,0002,00,00,000Total

0.0750.7510%1.101,65,00,000331,50,00,000305,00,000C

0.010.205%1.0542,00,0002140,00,000202,00,000B

0.010.0520%1.212,00,0001210,00,000101,00,000A

Wted

HPY

Mkt .

Wt

HPYHPREnd

Mkt.

Value

P eBeg

Mkt.

Value

P bNo. ofShare

Invt


COMPUTATION OF HOLDING PERIOD YIELD FOR APORTFOLIO Contd.

HPR = 2,19,00,000

---------------

2,00,00,000

= 1.095

HPY = HPR 1

=1.095 1 = 0.095 = 9.5 %


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Calculating Expected Rates Of Return

In the examples in the prior section, we examinedrealizedhistorical rates of return.

In contrast, an investor who is evaluating a futureinvestment alternative expects or anticipates acertain rate of return.

The investor might say that he or she expectstheinvestment will provide a rate of return of 10 percent,but this is actually the investors most likely estimate,also referred to as a point estimate.


Calculating Expected Rates Of Return contd.

An investor determines how certain the expected rateof return on an investment is by analyzing estimatesof expected returns.

To do this, the investor assigns probability values toall possiblereturns.

These probability values range from zero, whichmeans no chance of the return, to one, whichindicates complete certainty that the investment willprovide the specified rate of return.

These probabilities are typically subjective estimatesbased on the historical performance


The expectedreturn from an investmentdefined

Expected Return

= Sum of (Probability of Return) * (Possible Return)

=1

*i

RiPi


Perfect Certainty

Probability Distribution for risk free Investment


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Uncertainty

PROBABILITY DISTRIBUTION FOR RISKY INVESTMENT WITHTHREE POSSIBLE RATES OF RETURN



Choice

The expected rate of return for this investment isthe same as the certain return discussed in the firstexample; but, in this case, the investor is highlyuncertain about the actualrate of return.

This would be considered a risky investment becauseof that uncertainty.

We would anticipate that an investor faced with thechoice between this risky investment and the certain(risk-free) case would select the certain alternative.

This expectation is based on the belief that most

investors are risk averse, which means that ifeverything else is the same, they will select theinvestment that offers greater certainty.


Calculation

RATE OF

ECONOMIC CONDITIONS PROBABILITY RETURN

Strong economy, no inflation 0.15 0.20

Weak economy, above-average inflation 0.15 0.20

No major change in economy 0.70 0.10

The computation of the expected rate of return [E(Ri)] is asfollows:

E(Ri) = [(0.15)(0.20)] + [(0.15)(0.20)] + [(0.70)(0.10)]

= 0.07


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Measuring the Risk of Expected RateOf Return

Two possible measures of risk (uncertainty) havereceived support in theoretical work on portfoliotheory:

1. the varianceand

2. the standard deviationof the estimated distributionof expected returns.


Measures Of Risk

Variance is the mean of deviation fromArithmetic Mean


Measures Of Risk Standard Deviation is the square root of

variance


Expected Risk on a Portfolio Expected Risk on a Portfolio =

x A= Proportion Of security A in theportfolio

x B = Proportion Of security B in theportfolio

pAB = Corelation between returns ofsecurity A & B

2 2 2 2 22p A A B B A B AB A Bx x x x = + +


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Example

.50Correlation coefficient

60%40%Weight

.245.224Standard deviation

.060.050Variance

.020.015Expected return

Stock BStock A


Example contd.. What is the expected return and variance of this

two-security portfolio?

Solution: The expected return of this two-securityportfolio is:

[ ] [ ]

1

( ) ( )

( ) ( )

0 .4 ( 0 .0 1 5 ) 0 .6 ( 0 .0 2 0 )

0 .0 1 8 1 .8 0 %

n

p i i

i

A A B B

E R x E R

x E R x E R

=

=

= +

= +

= =

% %

% %


Example contd..Solution (contd): The variance of this two-security

portfolio is:

2 2 2 2 2

2 2

2

(.4) (.05) (.6) (.06) 2(.4)(.6)(.5)(.224)(.245)

.0080 .0216 .0132

.0428

p A A B B A B AB A Bx x x x = + +

= + +

= + +

=


A Relative Measure of Risk

In some cases, an unadjusted variance or standard deviationcan be misleading. If conditions for two or more investment

alternatives are not similar

that is, if there are major differences in the expected rates ofreturnit is necessary to use a measure of relative variabilityto

indicate risk per unit of expected return. A widely used relativemeasure of risk is the coefficient of variation (CV).

Coefficient of Variation (CV) = Standard Deviation of Returns

------------------------------------

Expected Rate of Return


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A Relative Measure of Risk contd

This measure of relative variability and risk is used byfinancial analysts to compare alternative investmentswith widely different rates of return and standarddeviations of returns.

As an illustration, consider the following twoinvestments:

INVESTMENT A INVESTMENT B

Expected return 0.07 0.12

Standard deviation 0.05 0.07


A Relative Measure of Risk contd

CV A = 0 05

-------= 0 714

0 07

CV B= 0 07

= 0 583

0 12


Those who in Quarrel interpose mustoften wipe a bloody nose.

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