Portfolio Full portion.pptx

8/15/2019 Portfolio Full portion.pptx

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PORTFOLIO

MANAGEMENT

Module I


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Introduction

Security analysis

Investment

Investment in single security

Combination of securities

It is called the portfolio of the dierent

nancial assets


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Contd…

For reducing the risks, an individual shows a

tendency to invest his money in a group of

securities

Such a group of security is called a portfolio

It helps to reduce risk without sacricing return

!n investor who understands the fundamental

principles and analytical aspects of portfolio

management has a better chance of success


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Portfolio

"ortfolio is a combination of securities such as stocks,

bonds and money market instruments

#he process of lending together the broad asset

classes so as to obtain optimum return with minimum

risk is called portfolio construction

$iversication of investment helps to spread risk over

many assets In a diversied portfolio, some securities

may not perform as e%pected but others may e%ceed

the e%pectation and make the actual return close to

anticipated return


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Portfolio Management

"ortfolio &anagement deals with the analysis of

individual securities as well as with the theory and

practice of optimally combining securities into

portfolio

For getting an optimal portfolio, an investor should

consider the risk return characteristics of allpossible portfolios

"ortfolio &anagement makes use of analytical

techni'ues of analysis and conceptual theories


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Contd…

"ortfolio &anagement comprises all the processes

involved in the creation and maintenance of an

investment portfolio It deals with securityanalysis, portfolio analysis, portfolio selection,

portfolio revision and portfolio evaluation

It is a comple% process which tries to make

investment activity more rewarding less risky


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Portfolio Construction

#here are two approaches to portfolio construction(

• Traditional approach )ere, the investor*s needs

in terms of income and capital appreciation are

evaluated and appropriate securities are selected

to meet the needs of the investor, by evaluating

the entire nancial plan of the investor

• Modern approach In this approach portfolios are

constructed to ma%imi+e the e%pected return for a

given level of risk


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#raditional !pproach

#raditional approach deals with the following two

decisions(

a $etermining the ob-ectives of the portfolio

b Selection of securities to be included in the portfolio

!teps In

Traditional

Approach


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Contd…

!nalysis of Constraints( Income needs, .i'uidity, safety of

principal, time hori+on, ta% considerations, etc

$etermination of ob-ectives( Current income, growth in

income, capital appreciation, preservation of capital, etc

Selection of portfolio( depends on the ob-ectives and

asset mi%

!ssessment of risk and return

$iversication


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Phases of Portfolio Management

#here are basically ve phases in the portfolio

management

0ach of these phases makes up an integral part

of the "ortfolio &anagement and the success of

it depends on the eectiveness in implementing

these phases


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Contd…

!EC"RIT# ANAL#!I!

#here are many securities available to investors

Security analysis is the initial phase of the portfolio

management process consisting of e%amining the risk7return characteristics of individual securities

1sing the two most important tools( Fundamental !nalysis

and #echnical !nalysis, security analysis is conducted

#he basic approach for investing in securities is to sell the

overpriced securities and purchase underpriced securities


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Contd…

PORTFOLIO ANAL#!I!

Security analysis provides the investor a set of protable

securities that can attain the nancial goals of the Investor

9y constructing a portfolio investors try to reduce the risk

and adopt diversication in investment

Portfolio analysis is the phase where a set of possible

portfolios are identied that include a given set of

securities and involves calculating their return and risk for

further analysis.


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Contd…

PORTFOLIO !ELECTION

!fter the portfolio analysis generates a set of

possible portfolios, the selection phase begins

"ortfolio selection phase involves rstly preparing

the set of e:cient portfolios and then from these

selecting the optimal portfolio for investment

Ecient portfolio is that portfolio which gives the

highest returns at a given level of risk.


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Contd…

PORTFOLIO RE$I!ION Since the nancial market and the economic conditions

are dynamic in nature the investor has to constantly

monitor the portfolio to make sure that it continues tobe optimal for investment

#hus, the portfolio has to be revised to ad-ust to the

changes It includes purchase of new securities and sale

of some e%isting securities

#hus, portfolio revision includes changing the mi% of

securities and their proportion in the portfolio


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Contd…

PORTFOLIO E$AL"ATION

"ortfolio evaluation is the process which is

concerned with assessing the performance of the

portfolio over a selected period of time in terms

of return and risk

It provides a feedback mechanism for improvingthe entire portfolio management process in order

to design a better portfolio ne%t time


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E$OL"TION OF PORTFOLIOMAMANGEMENT

Financial statement analysis ;in > 2ailroad

securities in 1S!

Common si+e analysis ;


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Role of PortfolioManagement

"ortfolio management was used by only few

selected people in India earlier, but the scenario

has totally changed today

"ortfolio management is been used widely in India

."D gave a uplift to "ortfolio management

Financial $erivatives like futures and 5ptions,

have evolved as ma-or contributors


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2isk and 2eturn

Module II


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RI!'

• E(er) in(estment *ears Ris+ and Return

• In general terms, ris+ is referred to as the

possi*ilit) of incurring loss for an in(estment-

• Financial meaning of ris+ is associated along

.ith return-

• It is de/ned as follo.s, 0Ris+ is the potential

for (aria*ilit) in returns-1

• The uncertaint) associated .ith return in an

in(estment introduces ris+ in the in(estment-


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Contd…

• An in(estment is characteri2ed *) e3pected

return and reali2ed return-

• E3pected return is the uncertain future

return that an in(estor e3pects to get from

his in(estment-

• Reali2ed return is the actual return that an

in(estor has o*tained from the in(estment

after maturit)-


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ELEMENT! OF RI!'

• The factors that cause (ariations in the returns

from an in(estment comprise of elements of ris+-

• These elements can *e classi/ed in t.o

categories

a4 "ncontrolla*le 5E3ternal factors to companies

a6ecting a large num*er of securities

simultaneousl)4

*4 Controlla*le 5Internal factors to companies

a6ecting onl) particular companies4


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Contd…

• The ris+ produced *) the uncontrolla*le factors

is called as s)stematic ris+-

• The ris+ produced *) the controlla*le factors is

called as uns)stematic ris+-

• The total (aria*ilit) in returns of a securit)

represents the total ris+ of that securit)- These

are the 7 components of ris+

Total Ris+ 8 !)stematic Ris+ 9 "ns)stematic Ris+


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!#!TEMATIC RI!'

• The impact of economic, political and socialchanges is s)stem:.ide and that portion of total

(aria*ilit) in securit) returns caused *) such

s)stem:.ide factors is referred to as s)stematic

ris+-

• This ris+ is su*:di(ided into ; of the follo.ing

ris+s

a4 Interest rate ris+

*4 Mar+et ris+

c4 Purchasing po.er ris+


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Contd…

INTERE!T RATE RI!'• It is a s)stematic ris+ that particularl) a6ects de*t

securities directl) and shares indirectl)-

• The mar+et price of *onds


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Contd…

MAR'ET RI!'

• This is a t)pe of s)stematic ris+ that a6ects shares-

• There e3ists a long:term (olatilit) in the mar+et due

to *usiness c)cles 5*ullish and *earish trends4 and

short:term (olatilit) caused *) changing in(estor

e3pectations-

• The stoc+ mar+et *eing (olatile leads to (ariations

in the returns of in(estors in shares- This (ariationin returns caused *) the (olatilit) of the stoc+

mar+et is referred to as the Mar+et Ris+-


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P"RC>A!ING PO?ER RI!'

• In=ation e3isting in an econom) leads to

lo.ering of the purchasing po.er of mone),

resulting an in(estor to e3perience decline in

purchasing po.er of his in(estment and also

return from his in(estment-

• This (ariation in in(estor returns caused *)

in=ation is called as Purchasing Po.er Ris+-

• Its impact is uniforml) felt on all securities in the

mar+et and thus it is called as a s)stematic ris+-

Contd…


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"N!#!TEMATIC RI!'

• The returns from a securit) ma) sometimes (ar)*ecause of certain factors a6ecting onl) the compan)

issuing such securit)-

• ?hen such (aria*ilit) of returns occurs *ecause of such

/rm:speci/c factors, it is +no.n as "ns)stematic ris+-

• This ris+ ma) ta+e the follo.ing t.o forms

a4 @usiness Ris+ The operating en(ironment of the

compan)

*4 Financial Ris+ The /nancing pattern adopted *) the

compan)


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Contd…

• @usiness Ris+ arises from the ina*ilit) of a

/rm to maintain its competiti(e edge and the

gro.th or sta*ilit) of the earnings- It can *e

internal or e3ternal-

• Internal @usiness Ris+

Fluctuations in the sales

Research Be(elopment

Personnel management

Fi3ed cost

!ingle product


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• E3ternal @usiness Ris+

!ocial and regulator) factors

Political ris+

@usiness c)cle

Contd…


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@"!INE!! RI!'

• Each compan) operates .ithin a particular operatingen(ironment comprising *oth internal en(ironment

5.ithin the /rm4 and e3ternal en(ironment 5outside the

/rm4-

• The impact of these operating conditions is re=ected in

the operating costs of the compan)- If re(enue declines

5.ith high /3ed costs4 operating pro/t reduces, .ith high

*usiness ris+-

• Thus, @usiness Ris+ is the function of the operating

conditions faced *) a compan) and is the (aria*ilit) in

operating income caused *) the operating conditions of

the compan)-

Contd…


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FINANCIAL RI!'

• It is a function of /nancial le(erage 5.hich is the

use of de*t in the capital structure4-

• !ince de*t creates a /3ed pa)ment 5interest4, it

creates more (aria*ilit) in EP! 5Earnings Per !hare4-

• The increase or decrease in EP! in response to

changes in operating pro/t .ould *e much .ider in

the case of a le(ered /rm 5a compan) ha(ing de*t

in its capital structure4 than in case of an unle(ered

/rm-

Contd…


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• This (aria*ilit) in EP! due to the presence of

de*t in the capital structure of a compan) is

referred to as Financial Ris+ -

• This is speci/c to each compan) and forms

part of its uns)stematic ris+-

Contd…


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MEA!"REMENT OF RI!'

• The uanti/cation of ris+ is necessar) for conductinga thorough in(estment anal)sis-

• It is assumed that ris+ in the in(estment is

associated .ith its return- Thus, ris+ cannot *e

measured .ithout reference to return, .hich

depends on cash in=o.s from the in(estment-

E3pected return the pro*a*ilit) .eighted a(erage of

all the possi*le returns-

Ris+ can *e measured *) (ariance or standard

de(iation of the pro*a*ilit) distri*ution of possi*le

returns-


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MINIMI!ING RI!' EDPO!"RE

• Mar+et Ris+ Protection

– @) stud)ing mar+et *eha(iour

– Calculations of standard de(iation and *eta to chec+

(olatilit)

– >old the stoc+ for a long period of time

• Protection Against Interest Rate Ris+

– >old in(estment till maturit)

– @u)ing of T:@ills and *onds of short term maturit)

– Maturit) di(ersi/cation 5in(est in *onds .ith

di6erent maturit) dates4


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%"E!TION! &

& &


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PORTFOLIO

ANALYSIS

Module III


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INTRODUCTION

Analysis of investment for a single security is done by

comparing the risk and return of the particular

individual security.

Investors are always risk averse but want good

returns for their investment.

Thus, the investors generally never prefer to opt forone individual security, they opt for a combination of

different securities put together.


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CONTD…It is assumed that money invested in several

securities simultaneously will tend to adjustment ofloss in one security with the gain in the other

securities.


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CONTD…

Group of securities held together as an investment is

Portfolio.

The process of creating a portfolio for increasing return

and minimizing risk by spreading it over all securities

is called Diversification.

From the same set of securities different portfolios can

be created with varying proportions.

Determining the efficiency of the portfolios is one of the

major concern for decision making.


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CONTD…

Determining the expected return and risk of each

portfolio that can be created from a set of selected

securities is the first step in portfolio management

and is called asPortfolio Analysis.

Portfolio Analysis involves:

a) Generating list of securities for inclusion

b) Expected return of a Portfolio

c) Risk of a Portfolio


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PORTFOLIO-MARKOWITZ MODEL

Harry Markowitz introduced the concept of correlationamong the different stocks’ returns in the construction

of a portfolio.

This model is based on the belief that holding two

stocks is less risky than holding one stock.

Example: Holding stocks from Automobile, IT and

Banking companies together is better than having all

the investment only in IT companies.


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CONTD…

Building up an optimum portfolio is a very difficult task.

Markowitz provides the solution to this with the help of risk

and return relationship.

Assumptions for the Markowitz Model:

a) Individual investor estimates risk on the basis of variability

of returns (Variance)

b) Investor’s decision is solely based on the expected return

and variance of returns only.

c) For a given level of risk, investor prefers higher return to

lower return. (lower risk than higher risk).


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EXPECTED RETURN OF A PORTFOLIO

The expected return of a portfolio of assets is simply

the weighted average of the return of the individual

securities held in the portfolio.

The weight for each of the returns is the proportion

of that security in the portfolio investment.

Expected return for portfolio is calculated as follows:rp = ∑ xi ri


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RISK OF A PORTFOLIO

Risk is generally measured in statistical terms.The measures used for measuring risk in investment

are variance of return and standard deviation of

return.

These tools measure the extent to which returns are

expected to vary around an average over time.

Since the portfolio has combination of securities the

risk characteristics of each security within the

portfolio has to be considered.


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CONTD…

The interactive risk of individual securities in a portfolio

refers to the how the returns of a security move with the

returns of other securities in the portfolio and contribute

to the overall risk of the portfolio.

Covariance is the statistical measure that indicates the

interactive risk of a security relative to others in a

portfolio of securities.

Thus, the way security returns vary with each other

affects the overall risk of the portfolio.


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CONTD…

The covariance between two securities X and Y

can be calculated as follows:

Covxy = ∑ [ Rx - Rx ] [ Ry - Ry ]

N

Covxy= Covariance between x and yR x = Return of security x

R y = Return of security y

Rx = Expected return or mean return of x

Ry = Expected return or mean return of y

N = Number of observations

CONTD


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CONTD…

If the returns of the two securities move in the samedirection consistently the covariance would be

positive.

If the returns of the two securities move in opposite

direction consistently the covariance would be

negative.

If the movements of returns are independent of each

other, covariance would be close to zero.


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COEFFICIENT OF VARIATION

Covariance can be standardized to facilitate

comparison.

The measure that divides the covariance between

two securities by product of the standard

deviation of each security is called asCoefficient

of correlation.

rxy = Covxy

x y

CONTD


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The correlation coefficients may range from -1 to +1.

-1 indicates negative whereas +1 indicates positive

correlation between security returns.

A value close to zero indicates that the returns are

independent.

CONTD…

PORTFOLIOVARIANCE


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PORTFOLIO VARIANCE

The variance of a portfolio is the risk faced by the

portfolio.

Portfolio varianceis the relationship between each

security in the portfolio with every other security as

measured by the covariance of return, along with the

weighted average of the variances of individual

securities in the portfolio.

2p = x12 12 + x22 22 + 2 x1x2 (r12 12)

Note: Portfolio standard deviation can be obtained by taking

the square root of portfolio variance

CONTD


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Thus, the risk and return of a portfolio depends on

two sets of factors:

a) The returns and risks of individual securities and

the covariance between securities in the portfolio.

b) The proportion of investment in each security.

) The first set are parametric factors (Out of control

of investor) and second are choice variable (In

investor’s control).

CONTD…


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REDUCTION OF PORTFOLIO RISK

THROUGH DIVERSIFICATION

The process of combining securities in a portfolio is

known asDiversification.

The aim of diversification is to reduce total risk

without sacrificing portfolio return.

The effect of diversification can be studied if we

observe the impact of correlation on portfolio risk

based on the following cases:

CONTD


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a) Security Returns Perfectly Positively Correlated

(Correlation is +1)

b) Security Returns Perfectly Negatively Correlated

(Correlation is -1)

c) Security Returns Uncorrelated

(Correlation is Zero)

CONTD…

CONTD


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Security Returns Perfectly Positively Correlated

The correlation coefficient here is +1 and the returns of

securities move up and down together.

Diversification here provides only risk averaging andno risk reduction because the portfolio risk cannot be

reduced below the individual security risk.

Thus, when security returns are perfectly positivelycorrelated, diversification is not a good strategy.

CONTD…

CONTD


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Security Returns Perfectly Negatively Correlated

The correlation coefficient here is -1 and the returns of

securities always move in exactly opposite directions.

The portfolio may become entirely risk free when

security returns are perfectly negatively correlated.

Thus, when security returns are perfectly negatively

correlated, diversification becomes a highly productive

activity.

In reality however, it is rare to find securities that are

perfectly negatively correlated.

CONTD…

CONTD


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Security Returns Uncorrelated When the returns of two securities are entirely

uncorrelated, the correlation coefficient would be zero.

Here the portfolio standard deviation is less than the

S.D. of individual securities in the portfolio.

Thus, when security returns are uncorrelated,

diversification reduces risk and is a productive activity.

CONTD…


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PORTFOLIOS WITH MORE THAN

TWO SECURITIES

An optimal portfolio is one where there are always

more than two securities included.

An investor can make the portfolio risk arbitrarily

small by including a large number of securities with

negative or zero correlation in the portfolio.

But, in practice the benefits of diversification are

limited, as no securities show negative or even zero

correlation.

CONTD


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The total risk of an individual security comprises

of two components:

Systematic risk (Market risk)

Unsystematic risk (Individual security risk)

CONTD…


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RISK-RETURN CALCULATIONS OF

PORTFOLIOS WITH MORE THAN TWO

SECURITIESExpected return calculations

Portfolio variance calculations

Standard Deviation calculations


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QUESTIONS ? ? ?


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PORTFOLIO SELECTION

Module IV

INTRODUCTION


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INTRODUCTION

Determining the expected return and risk of each

portfolio that can be created from a set of selected

securities is the first step in portfolio management called

as Portfolio Analysis.

After the analysis Portfolio construction requires

generation of a portfolio that provides the highest return

with lowest risk.


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he portfolio that provides the highest return and the

lowest risk is called as the !ptimal Portfolio.

he process of finding the optimal portfolio is described

as Portfolio "election.

he model followed for portfolio selection is the

#arkowit$ #odel.

Contd…


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he selection of portfolios by the investor will be guided

by two criteria%

a& 'iven two portfolios with same expected return( the

investor would prefer the one with the lower risk

b& 'iven two portfolios with the same risk( the investor

would prefer the one with the higher expected return

Contd…


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FEASIBLE SET OF PORTFOLIOS

)orming the feasible set of portfolios with limited set of securitiesand large number of portfolios( adopting different proportions of

securities is called as the Portfolio !pportunity "et.

*n this Portfolio !pportunity "et( there will be some portfoliosdominating the others.

Portfolios that are dominated by other portfolios are called as

*nefficient portfolios.

he portfolios that dominate the other portfolios are called as the

+fficient portfolios.


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he feasible set of portfolio represents all portfolios that

can be constructed from a given set of stocks.

An efficient portfolio is one that offers%

• he maximum return for a given amount of risk

• he minimum risk for a given amount of return

he collection of efficient portfolios is called the efficientset or efficient frontier.

Contd…


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he portfolio with the least amount of risk in the

opportunity set of portfolios is called as the 'lobal

minimum variance portfolio.

he portfolios with minimum risk and maximum return

,the north-west boundary of the shaded area& are more

efficient than all the other portfolios.

Contd…


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THE EFFICIENT FRONTIER

he boundary with the minimum risk and maximum

return among the portfolio opportunity set is called the

+fficient )rontier .

he set of portfolios lying between the global minimum

variance portfolio and the maximum return portfolio on

the efficient frontier represents the efficient set of

portfolios.

C d


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Contd…

he efficient frontier is a concave curve in the risk-return

space that extends from the minimum variance portfolio to

the maximum return portfolio.


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SELECTION OF OPTIMAL PORTFOLIO

ational investors will obviously prefer to invest in the

efficient portfolios depending on the investor/s degree of

aversion to risk.

0

1

A highly risk averse investor/s

portfolio will lie here

An investor who is not risk

averse will hold a portfolio here


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hus( the selection of the optimal portfolio depends on

the investor/s risk aversion or on his risk tolerance.

his is graphically represented through a series of risk

return utility curves called *ndifferent 0urves.

Contd…

*2

*3*4

*ndifference curve

+fficient frontier !


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+ach of the indifference curves represents different

combinations of risk and return( all of which are equally

satisfactory to the concerned investor.

he investor is said to indifferent between the successivepoints in the curve.

+ach curve moving upward represents a higher level of

satisfaction or utility. And the investor is interested to

maximi$e his utility by moving up to the higher utility

curve.

Contd…


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he optimal portfolio for an investor would be the one

at the point of tangency between the efficient frontier

and his risk-return utility or indifference curve.

*n the diagram( point ! represents the optimal curve.

Contd…

*ndifference curve

+fficient frontier !


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LIMITATIONS OF MARKOWITZ MODEL

hough #arkowit$ model proved to be very beneficial it

had certain drawbacks as follows%

a& 5arge number of input data required for calculations.

b& 0omplexity of computations required.

)1ecause of these practical difficulties with #arkowit$

#odel( simplification was needed in the amount and type

of input data required to perform portfolio analysis.

SINGLE INDE MODEL


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SINGLE INDE MODEL

he basic view of the "ingle *ndex #odel is that all stocksare affected by movements in the stock market.

As markets move up the share price also increases and as

markets move down so does the share price.

his co-movement of stocks with a market index may be

studied with the help of a simple linear regression analysis(

taking the returns on an individual security as the

dependent variable and the returns on the market index as

the independent variable.


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he return of an individual security is assumed todepend on the return on the market index.

*t is expressed as follows%

i 6 7i 8 9i m 8 ei

#easurement under "ingle *ndex #odel includes%

a& *ndividual "ecurity risk and security return

b& Portfolio risk and portfolio return

Contd…


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Alpha represents the individual security/s return that is

independent of the market/s performance.

1eta is the measure of a stock:s sensitivity of returns to

changes in the market. *t is a measure of systematic risk.

Contd…

MULTI INDE MODEL


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MULTI INDE MODEL

#ulti-*ndex model increases the scope of the "ingle *ndex

#odel.

#ulti-*ndex model attempts to identify and incorporate some

non-market or extra market factors that cause securities to

move together also into the model.

hese extra-market factors are a set of economic factors that

account for common movements in stock prices beyond that

accounted for by the market index itself.

+.g.% *nflation( real economic growth( exchange rates( etc.

C d


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A multi-index model incorporating the market effect and

three extra-market effects takes the following form%

i 6 7i 8 9mm 8 922 8 933 8 944 8 ei

A multi-*ndex model is an alternative to the single index

model. ;owever( it is more complex and requires more

data estimates for its application.

Contd…


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QUESTIONS ? ? ?


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89

Capital Asset Pricing Model

(CAPM)

Module V


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90

Introduction

In portfolio selection phase it is seen that

investors search for efficient portfolios and

select an optimal portfolio.

The Markowitz theory provides tools for

analysis and selection of portfolio.

CAPM was developed in 60s by researchers!illiam "harpe# $ohn %intner and $an Mossin.


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Capital Asset Pricing Model

The Capital Asset Pricin& Model derives the

relationship between the e'pected ret(rn and risk

of individ(al sec(rities and portfolios in the capital

markets )if everyone behaved in the way the

portfolio theory s(&&ested*.

+ere the re,(ired rate of ret(rn of an asset is

havin& a linear relationship with asset-s beta val(e

)(ndiversifiable or systematic risk*.91

F d t l N ti f P tf li Th


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Fundamental Notions of Portfolio Theory Characteristics of Investment/ I"1 2 3T45

The risk is red(ced thro(&h diversification and th(s

portfolio is created.

!ith the &iven set of sec(rities a n(mber ofportfolios can be created by alterin& the proportion

of f(nds.

Portfolio analysis has to be considered. After portfolio analysis# efficient portfolios are

listed and optimal portfolio is selected.92

d


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Contd…

"ystematic risk )market risk* cannot be eliminated. Market risk is indicated by the sensitivity of a

sec(rity to the movements of the market and is

meas(red by the beta coefficient.

ational investors e'pect ret(rns comparative to

its risk )hi&h risk / hi&h ret(rn*# th(s# the ret(rn is

e'pected to be correlated with this risk only.

93

d


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Contd…

The Capital Asset Pricin& Model &ives the nat(re

of the relationship between the e'pected

ret(rn and the systematic risk of a sec(rity.

This theory states that the rate of ret(rn of an

asset is havin& a linear relationship with the

assets beta val(e which is known as systematic

risk.

94


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Assumptions of CAPM

* Investors make investment decisions based on risk

ret(rn assessments meas(red in terms of e'pected

ret(rns and standard deviation of ret(rns.

7* The p(rchase or sale of a sec(rity can be

(ndertaken in infinitely divisible (nits.

* P(rchases and sales by a sin&le investor cannot

affect prices.

95


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Contd…

8* There are no transaction costs.

9* There are no personal income ta'es.

6* The investor can lend or borrow any amo(nt of f(nds

desired at a rate of interest e,(al to the rate of

riskless sec(rities.

:* The investor can sell short any amo(nt of any shares.

;* Investors share homo&eneity of e'pectations.

96

Efficient frontier with riskless lending


97/157

Efficient frontier with riskless lending

and orrowing !hen an opport(nity is &iven to the investors they can

mi' riskfree assets with risky assets in a portfolio to

obtain a desired rate of ret(rn.

A riskfree asset is one whose ret(rn is certain s(ch as

a &overnment sec(rity. et(rn is certain# so risk is zero.

The investor can invest a portion of his f(nds in the

riskless asset which is considered e,(ivalent to lendin&

at the risk free asset-s rate of ret(rn )f *.

97

Contd


98/157

Contd…

In the same way# the investor may borrow at the same

riskless rate for the p(rpose of investin& in a

portfolio of risky assets.

+e may his own f(nds as well as some borrowed f(nds

for investment.

The efficient frontier is a concave shape.


99/157

99

Rp

(Rf)

B

C

A

Contd…

Contd…


100/157

Concave c(rve A


101/157

!isk and !eturn using CAPM

!ET"!N#

!c $ %!m & '( ) %* !f

!I+,#

- c $ % - m > ) ? @* f

101

Contd…


102/157

Considerin& borrowin& f(nds by the investor for investin&

in the risky portfolio an amo(nt lar&er than his ownf(nds.

@ is the proportion of investor-s f(nds invested in the

risky portfolio# then we can envisa&e three sit(ations/ IB@ )investors f(nds are f(lly committed to the riskyportfolio*

@ D )only a fraction of the f(nds is invested in the riskyportfolio and the remainder is lend at the risk free rate*

@ E )means the investor is borrowin& at the risk free rate andinvestin& an amo(nt lar&er than his own f(nds in the riskyportfolio# called a levered portfolio*

102

Contd…

! t . !i k f P tf li


103/157

!eturn . !isk of Portfolio

The !ET"!N of a levered portfolio can be

calc(lated as follows/

!/ $ % !m ) '% ) (* !f

103

0ross return earned yin1esting the orrowed

funds as well asin1estor2s own funds inthe risky portfolio

The cost of orrowingfunds which is deducted

from the gross returnsto otain the net returnon the le1ered portfolio

Contd…


104/157

The !I+, of a levered portfolio can be calc(lated as

follows/- / $ % - m

The ret(rn and risk of the levered portfolio are lar&er

than those of the risky portfolio. The levered portfolio wo(ld &ive increased ret(rns with

increased risk.

The ret(rn and risk of all levered portfolios wo(ld lie in astrai&ht line to the ri&ht of the risky portfolio )< in the

dia&ram* 104

Contd…


105/157

105

Rp

(Rf)

B

C

A

Th(s# lendin& and borrowin& &ives (s an efficient

frontier that is a strai&ht line thro(&ho(t# that setso(t all the alternative combinations of the risky

portfolio with risk free borrowin& and lendin&.

%ine from f to < E combinations of the risky

portfolio and riskfree asset

%ine beyond < E

represents all the levered portfolios

Contd…


106/157

%evered portfolios are those with combinations of

the risky portfolio with borrowin&.

%endin& is combinin& the risky portfolio with risk

free asset.


107/157

Investors who do not prefer risk takin& will chooseto lend and hold a combination of risky assets and

the risk free asset.

"ome investors who are ready to take risk# chooseto borrow and invest more in the risky portfolio.

107


108/157

Capital Market /ine

108

Contd…


109/157

Contd…

Assuming all investos !ave i"enti#al e$pe#tations% t!e&

geneall& !ave t!e same effi#ient fontie'

!e ABC s!os t!e investos potfolio of is*& assets'

An& point +eteen B , C gives supeio etun #ompae"to B , A'

-f investos #an #om+ine is*less assets it! is*& assets%

(t!e staig!t line) it epesents all possi+le #om+inations of

is*less an" is*& assets'

109

Contd…


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!e line fome" +& t!e a#tion of all investos mi$ing t!e

ma*et potfolio (is*& assets) it! t!e is* fee asset is

*non as t!e Capital Market Line'

C./ gives t!e "esia+le set of investment oppotunities

+eteen is* fee an" is*& investments' -t povi"es a is*

etun elations!ip an" a measue of is* fo effi#ient

potfolios'

110

Contd…


111/157

The +ecurity Market /ine

111

Contd…


112/157

!e C./ s!os t!e is* etun elations!ips of all

effi#ient potfolios% +ut e$#lu"es ineffi#ient potfolios' But%

CA. in#lu"es is* etun elations!ips fo all se#uities

an" potfolios (effi#ient , ineffi#ient)'

./ +asi#all& moe applies to se#uities' An" t!e is*

fa#to t!at is use" !ee is Beta'

!us% e$pe#te" etun of se#uit&potfolio is elate" to t!e

is* of t!e se#uit&potfolio t!at is measue" +& Beta'

112

Contd…


113/157

Beta is a measue of t!e se#uit&s sensitivit& to #!anges inma*et etun'

Beta 1 !ig!e sensitivit& to ma*et #!anges

Beta 1 loe sensitivit& to ma*et #!anges

Beta 1 se#uit& moves in same "ie#tion as t!e ma*et

!us% t!e of t!e ma*et is ta*en as 1'

113

Contd…


114/157

A is* fee asset !as an e$pe#te" etun euivalent to R f an" Beta

#oeffi#ient of eo' !e ma*et potfolio . !as a +eta #oeffi#ient of

one an" e$pe#te" etun euivalent to R m'

A staig!t line :oining t!ese to points is *non as t!e Security

Market Line (SML)'

!e ./ povi"es t!e elations!ip +eteen t!e e$pe#te" etun an"

+eta of a se#uit&potfolio' -t is epesente" as;

R i R f < i (R m = R f )

114

Risk-free return

Risk premium of market

Expected return

Contd…


115/157

As t!e value of goes on in#easing t!e e$pe#te" Ri also

goes on in#easing'

e#uities !i#! !ave of moe t!an 1 ae #alle"

aggessive se#uities'

An" se#uities it! less t!an 1 ae #alle" "efensive

se#uities'

115

CAPM Model


116/157

CAPM Model

!e elations!ip +eteen is* an" etun esta+lis!e" +& t!ese#uit& ma*et line is *non as t!e Capital Asset Pricing

Model'

-t is a linea elations!ip% as !ig!e t!e (is*) lage is t!e

e$pe#te" etun +& t!e investo'

!is is not suita+le fo in"ivi"ual se#uities +ut fo

potfolios (+ot! effi#ient as ell as ineffi#ient)'

R i R f < i (R m = R f )

116

Contd…


117/157

!e CA. mo"el suggests t!at s&stemati# is* is t!e onl&impotant inge"ient in "etemining e$pe#te" etun'

As investos #an eliminate uns&stemati# is* t!oug!

"ivesifi#ation% t!e& e$pe#t !ig! etuns fo +eaing t!e

s&stemati# is*'

!us% t!e elevant is* of an asset is its s&stemati# is* an"

not t!e total is*'

117

SML and CML


118/157

SML and CML

Capital Market /ine +ecurity Market /ine

isk is defined as total risk isk is defined as systematic riskisk is meas(red by ". F.

)*isk is meas(red by


119/157

Pricing of Securities with CAPM

!e CA. is use" fo evaluating t!e pi#ing of se#uities%an" povi"es a fameo* to assess !et!e a se#uit& is

#oe#tl& pi#e"% ovepi#e" o un"epi#e"'

>!en t!e e$pe#te" etun an" t!e estimate" etun of a

se#uit& "oes not mat#! t!e se#uit& ma& +e #alle" as ove=

pi#e" o un"e=pi#e"'

!e estimate" etun on a se#uit& #an +e #al#ulate" as;Ri (1 ? 2) < @1

0

119

Contd…


120/157

120

The framework for eval(ation of pricin& of sec(rities can be

(nderstood better with the followin& dia&ram

Contd…


121/157

!e "iagam s!os t!e ./% it! Beta values plotte" on

a$is an" estimate" etuns ae plotte" on t!e a$is'

-f points of estimate" etuns o##u on t!e ./ line% t!e& ae

#oe#tl& pi#e"'

-f t!e points o##u a+ove t!e ./ line in t!e same is* #lass

(estimate" etun is !ig!e t!an e$pe#te" etun) t!e&

un"epi#e"'

-f t!e points o##u +elo t!e ./ line in t!e same is* #lass

(estimate" etun is loe t!an e$pe#te" etun) t!e& ovepi#e"'

121

Contd…


122/157

CA. #an +e use" to i"entif& un"epi#e" an" ovepi#e"se#uities'

$pe#te" etun stimate" etun Dn"epi#e"

$pe#te" etun stimate" etun Evepi#e"

($pe#te" etun) R i R f < i (R m = R f )

!us% CA. postulates t!at eve& se#uit& is e$pe#te" to ean a

etun #ommensuate it! its is* as measue" +& +eta'

122


123/157

3"E+TI4N+ 5 5 5

123

MOB"LE $I


124/157

PORTFOLIO RE$I!ION

MOB"LE $I

Introduction


125/157

IntroductionPortfolio management stresses the importance of

portfolio anal)sis and portfolio selection so as to

o*tain the *est or optimal portfolio that gi(es

ma3imum returns .ith minimum ris+-

@ut, the ne3t challenge is to +eep the optimal

portfolio Optimal for a long time- !ince the mar+et

is d)namic the portfolio also tends to change o(er

time-

This can *e achie(ed *) adopting 0Portfolio

Re(ision1-

Portfolio Re(ision


126/157

Portfolio re(ision in(ol(es changing the e3isting

mi3 of securities in a portfolio- It can *e either

changing the securities included in the portfolio

or altering the proportion of funds in(ested in

the securities-

Portfolio re(ision is the process of adusting the

e3isting portfolio in accordance .ith the

changes in /nancial mar+ets and the in(estors

position so as to ensure ma3imum return from

the portfolio .ith the minimum of ris+-

Contd


127/157

• Thus, portfolio re(ision or adustment

necessitates purchase and sale of

securities-

• The o*ecti(e of portfolio re(ision is

ma3imi2ing the return for a gi(en le(el of

ris+ or minimi2ing the ris+ for a gi(en le(el

of return-

Need for Re(ision


128/157

The need for portfolio re(ision ma) arise

from changes in the /nancial mar+et or

changes in the in(estors position 5his

/nancial status and preferences4-

H4 Mar+et related

!ince the /nancial mar+ets change, it .ill

a6ect the (alue of the portfolio, hence

portfolio has to *e re(ised-

Contd


129/157

74 In(estor related

A(aila*ilit) of additional funds for

in(estment

Change in ris+ tolerance

Change in the in(estment goals

Need to liuidate a part of the portfolio to

pro(ide funds for some alternati(e use

Constraints In Portfolio


130/157

Re(isionThe practice of portfolio re(ision in(ol(ingpurchase and sale of securities gi(es rise to

certain pro*lems .hich act as constraints in

portfolio re(ision-The major constraints include the following:

a4 Transaction cost

*4 Ta3es

c4 !tatutor) stipulations

d4 Intrinsic dicult)

Contd


131/157

Transaction Cost

Transaction costs such as commission and

*ro+erage are in(ol(ed .hile trading 5purchase

or sale of securities4- Thus, increase in trading

ma) lead to increase in these costs and

reduction in gains from the portfolio-

Thus transaction costs act as constraints intimel) re(ision of portfolio-

Contd


132/157

Ta3es

Ta3es are applica*le on capital gains arising from

sale of securities- The) can *e long:term or short:

term-

Generall), Long:term capital gains are ta3ed at a

lo. rate and short:term capital gains are ta3ed at a

high rate-

Freuent selling for re(ision ma) lead to short:term

gains and in turn lead to high ta3 pa)ments *) the

in(estor and thus, it is termed as a constraint-

Contd


133/157

!tatutor) !tipulations

The largest portfolios in e(er) econom) is

managed *) in(estment companies and mutual

funds-

These are institutional in(estors and are

normall) go(erned *) certain statutor)

stipulations regarding their in(estment acti(it)-

These stipulations or rules ma) act as

constraints in portfolio re(ision-

Contd


134/157

Intrinsic dicult)Portfolio Re(ision is a dicult and time

consuming tas+-

There are di6erent approaches adopted tounderta+e portfolio re(ision that are not clearl)

de/ned-

This dicult) of carr)ing out portfolio re(ision

itself ma) act as a constraint to portfolio

re(ision-

Portfolio Re(ision!trategies


135/157

!trategies

Portfolio re(ision ma) adopt an) of the

follo.ing t.o strategies

a4 Acti(e re(ision strateg)

*4 Passi(e re(ision strateg)

The choice of the strateg) .ould depend

on the in(estors o*ecti(es, s+ills,

resources and time-

Contd


136/157

Acti(e Re(ision strateg) in(ol(es freuent

and su*stantial adustments to the portfolio

.ith the o*ecti(e to *eat the mar+et-

Passi(e strateg) in(ol(es onl) minor and

infreuent adustments to the portfolio o(er

time that are carried out according to

predetermined rules and procedures called

formula plans-

Acti(e and Passi(e re(isionstrategies


137/157

strategiesActi(e re(ision strateg) Passi(e re(ision strateg)

Fre'uent changes in theportfolio ;fre'uent portfoliorevision

Infre'uent changes in theportfolio ;Infre'uent portfoliorevision

9elieve that securitymarkets are not continuouslye:cient

9elieve that security

markets are e:cient

!ssume that investors haveheterogeneous e%pectationsregarding risk and return of

securities

!ssume that investors havehomogeneous e%pectationsregarding risk and return of

securitiesIncludes carrying outportfolio analysis andportfolio selection everytime during revision

"ortfolio analysis andselection is done only onceand then only minorchanges are carried out

Formula plans


138/157

The aim for e(er) in(estment is to ma+e higher

returns .ith minimum ris+, and this is carried on *)

purchase and sale of securities-

?hen prices of securities are lo. the) are purchased

and .hen prices of securities are high the) are soldto ma+e pro/t .ith the price di6erential-

@ut in(estors are unsure a*out the time .hen these

purchase and sale decisions should *e ta+en- Thus,

in(estors .ill not *e a*le to ta+e the *ene/t from

price =uctuations-

h i h i l i i h i

Contd


139/157

There are certain mechanical re(ision techniues

or procedures de(eloped to ena*le the in(estorsto *ene/t from price =uctuations in the mar+et

*) *u)ing stoc+s .hen prices are lo. and selling

them .hen prices are high- These techniues are

referred to as Formula Plans-

Formula plans consist of predetermined rules

regarding .hen to *u) or sell and ho. much to

*u) or sell- These rules call for speci/ed actions

.hen there are changes in the securities mar+et-

The formula plans specif) predetermined rules for

Contd


140/157

The formula plans specif) predetermined rules for

the transfer of funds from the aggressi(e portfolio

to the defensi(e portfolio and (ice (ersa-

These rules ena*le the in(estor to automaticall)

sell shares .hen their prices are rising and *u)

shares .hen their prices are falling-

The di6erent formula plans include

a4 Constant Rupee $alue Plan

*4 Constant Ratio Plan

c4 Bollar Cost A(eraging

Constant Rupee $aluePl


141/157

PlanIn this plan, the in(estor constructs t.o portfolios,

one aggressi(e 5consisting of euit) shares4 and the

other defensi(e 5consisting of *onds and de*entures4-

Objective of the plan Keep the original amount

invested in the aggressive portfolio constant.

?hen share prices increase, shares from aggressi(e

portfolio ha(e to *e sold 5and deposited in defensi(e

portfolio4, and .hen share prices decrease, sharesha(e to *e purchased in aggressi(e portfolio 5*)

selling units from defensi(e portfolio4-

In implementation of this plan, funds .ill *e

Contd


142/157

p p ,

transferred from one portfolio to the other,

.hene(er the (alue of the aggressi(e portfolio

increases or decreases to the predetermined

le(el-

Implementations of Constant Rupee $alue Plan

.ill mainl) depend on the action points

selected-

Action points are the points .hen the in(estor

should ma+e the transfer of funds to +eep the

rupee (alue of the aggressi(e portfolio

Constant Ratio Plan


143/157

This plan is similar to the Constant Rupee $alue Plan,

in .hich the in(estor .ould construct t.o portfolios,one aggressi(e and the other one defensi(e-

The onl) (ariation in this plan is that, instead of

actions points, here the ratio *et.een the

in(estments in the aggressi(e portfolio and the

defensi(e portfolio should *e predetermined- E-g-

HH, or H-JH, etc-

Objective of the plan: Keep the decided ratio

constant by readjusting the two portfolios when

share prices uctuate from time to time.

Contd


144/157

The decision of the constant ratio plan .illdepend on the re(ision point decided- E-g- K

-H, K -7, etc-

?hen the ratio *et.een (alues of theaggressi(e portfolio and the defensi(e portfolio

mo(es up or do.n from the pre:decided re(ision

points 5-H or -74, the portfolios .ould *e

adusted *) transfer of funds from one to the

other-

Bollar Cost A(eraging


145/157

This is +no.n as a method of passi(e portfolio

re(ision and is totall) di6erent from the

pre(ious t.o methods discussed-

Bollar cost a(eraging is the techniue of

*u)ing a /3ed dollar amount of a particular

in(estment on a regular schedule, regardless

of the share price- More shares are purchased.hen prices are lo., and fe.er shares are

*ought .hen prices are high-

Bollar:cost a(eraging lessens the ris+

E3ample for Bollar CostA(eraging


146/157

A(eraging

Contd


147/157

All formula plans assume that stoc+ prices

=uctuate up and do.n in c)cles-

If this plan is implemented o(er a complete

c)cle of stoc+ prices, the in(estor .ill o*tain his

shares at a lo.er a(erage cost per share than

the a(erage price pre(ailing in the mar+et o(er

the period-

It occurs *ecause more shares .ould *e

purchased at lo.er prices than at higher prices-


148/157

%"E!TION!&&&


149/157

PORTFOLIO EVALUATION

Module VI

Introduction


150/157

• Last step in the process of portfolio management where the

examination of the extent to which the objectives are met is

seen.

• The portfolio evaluation stage tries to judge whether the

portfolio is performing according to pre-specified standards

or not.

• Evaluation is an appraisal of performance, whether the

investment activity is carried out by individual investors

themselves or through mutual funds and investment

companies.

Need for Evaluation


151/157

Need for Evaluation

• There are various situations where portfolio evaluation

becomes essential. ome of the important ones are!

a" elf evaluation

b" Evaluation of #ortfolio $anagers

c" Evaluation of $utual %unds

Evaluation perspective


152/157

• #ortfolio construction involves combining severalsecurities with different proportions to achieve the stated

objective. &hile building a portfolio several transactions

of purchase and sale will ta'e place for revision.• Thus, the evaluation may be carried out from different

points of view.

a" Transaction view

b" ecurity view

c" #ortfolio view

Contd…


153/157

• Transaction view ! an investor may attempt to evaluate

every transaction of purchase and sale of securities.

&henever a security is bought or sold, the transaction is

evaluated as regards its correctness and profitability.

• ecurity view ! this view attempts to evaluate each

security included in the portfolio by comparing the

mar'et value and the purchase price. (t evaluates the

profitability of holding each security separately.

Contd…


154/157

• #ortfolio )iew ! if evaluation is done by adopting

Transaction view or ecurity view it would be

incomplete and misleading. #roper evaluation is

possible if ris' and return of the total investment.

• *ut since ris' and return is best defined at the portfolio

level and not at security or transaction level, the best

evaluation is portfolio evaluation.

Portfolio Evaluation


155/157

Portfolio Evaluation

• #ortfolio evaluation refers to the evaluation od the

performance of the portfolio.

• (t is essentially the process of comparing the returnearned on a portfolio with the return earned on one or

more other portfolios or even on a bench mar' portfolio.

Measurin Portfolio Return


156/157

Measurin Portfolio Return

• +is' djusted +eturns

a" harpes +atio +eward to )ariability"

b" Treynors +atio +eward to )olatility"• /ifferential return

a" 0ensens +atio /ifferential +eturn"

• /ecomposition of performance

a" %amas /ecomposition of total return


157/157

QUESTIONS???

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