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PORTFOLIO MANAGEMENT & MUTUAL FUNDS

Report OnRisk Management Perspective with respect to Emerging MarketsSubmitted By Moad Arsiwala (08PMP00716)

Submitted To Prof. Daveen B.S. Dhingra

IUD Evaluation Date: - 11th December, 2009The most vital decision regarding investing that an investor can make involves the amount of risk he or she is willing to bear. Most investors will want to obtain the highest

return for the lowest amount of possible risk. However, there tends to be a trade-off between risk and return, whereby larger returns are generally associated with larger risk. Thus, the most important issue for a portfolio manager to determine is the clients tolerance to risk. This is not always easy to do as attitudes toward risk are personal and sometimes difficult to articulate. The concept of risk can be difficult to define and to measure. Nonetheless, portfolio managers must take into consideration the riskiness of portfolios that are recommended or set up for clients. RISK An uncertainty that the actual outcome from an investment will differ from the expected outcome can be defined as risk. While evaluating a particular security or bunch of security i.e. portfolio investors give priority to two main aspects which are as under: Expected Return Risk involved Investors have a notion in their mind that a security should give maximum possible return with same level of risk or minimize the risk with respect to expected return. The risk that the value of on- or off-balance-sheet positions will be adversely affected by movements in equity and interest rate markets, currency exchange rates and commodity prices is called market risk. The main components of market risk are therefore equity, interest rate, FX, and commodity risk.

At the top of the pyramid, we have total market risk, which is the aggregation of all component risks.

In the middle of the pyramid, we see how financial instruments are driven by the underlying component risks. At the lowest level, market risk arises from fluctuating prices of financial instruments. In addition to market risk, the price of financial instruments may be influenced by the following residual risks: spread risk, basis risk, specific risk, and volatility risk. Spread risk is the potential loss due to changes in spreads between two instruments. For example, there is a credit spread risk between corporate and government bonds. Basis risk is the potential loss due to pricing differences between equivalent instruments, such as futures, bonds and swaps. Hedged portfolios are often exposed to basis risk. Specific risk refers to issuer specific risk, e.g., the risk of holding Yahoo! stock vs. an S&P 500 futures contract. How to best manage specific risk is a topic of debate. Note that according to the Capital Asset Pricing Model (CAPM), specific risk is entirely diversifiable. Volatility risk is defined as potential loss due to fluctuations in implied option volatilities and is often referred to as vega risk. Short option positions generally lose money when volatility spikes upward. Business risk is the risk of failing to achieve business targets due to inappropriate strategies, inadequate resources or changes in the economic or competitive environment. Credit risk, is the risk that a counterparty may not pay amounts owed when they fall due. Sovereign risk is the credit risk associated with lending to the government itself or a party guaranteed by the government. Liquidity risk is the risk that amounts due for payment cannot be paid due to a lack of available funds. Operational risk is the risk of loss due to actions on or by people, processes, infrastructure or technology or similar, which have an operational impact including fraudulent activities. Accounting risk is the risk that financial records do not accurately reflect the financial position of a company. Country risk is the risk that a foreign currency will not be available to allow payments due to be paid, because of a lack of foreign currency or the government rationing what is available.

Political risk is the risk that there will be a change in the political framework of the country. Industry risk is the risk associated with operating in a particular industry. Environmental risk, the risk that a company may suffer loss as a result of environmental damage caused by themselves or others which impacts on their business. Legal/regulatory risk is the risk of non-compliance with legal or regulatory requirements. Systemic risk is the risk that a small event will produce unexpected consequences in local, regional or global systems not obviously connected with the source of the disturbance. Reputational risk is the risk that the reputation of a company will be adversely affected.

NEED FOR PORTFOLIO As there is a saying that we should not put all eggs in one basket, same goes with investment dont block or invest all the funds available in one particular security but to diversify among different avenues. This gives rise to designing of portfolio of securities which contains bunch of potential stocks which ensure the best possible return at a manageable risk level. Beta measure is used to analyze to ensure sensitivity of security return with respect to fluctuations in overall market. Within a portfolio it is advised not to have exposure in one particular sector but to diversify among various sectors in order to eliminate the diversifiable or the unsystematic risk which is related to one particular company or one particular sector. Through diversification, adding of sufficient stocks in portfolio the unsystematic risk can be eliminated. But systematic risk cant be removed as it is related with the whole economy.

There are numerous ways of diversification: Diversification within an Industry Diversification across industries Diversify across geographical regions International Diversification Diversification across Asset Classes.

The investor should also keep in mind the perils associated with over diversification. There should not be too many securities in the portfolio that it creates difficulty in handling them. The question is how to determine the number of securities to be maintained within the portfolio. Generally portfolio should have a mix of ten to fifteen securities. It can be inferred that the number of securities should be limited to the extent that the investor is able to earn handsome amount of return with manageable risk.

PORTFOLIO SELECTION Efficient Frontier Investors select a portfolio which fall on the Efficient Frontier. Efficient Frontier is a group of securities within a portfolio where: Returns are maximized at same level of risk Minimizing the risk level with same expected returns.

Generally risk level observed in emerging markets is far higher compared to developed markets. The situation prevailing in emerging markets are highly volatile which demands constant monitoring of the portfolio and up gradation in portfolio from time to time. Sharp Optimization Model This model is used while selecting a portfolio comprising of potential securities. There are steps involved in this particular model. Rank Securities based on excess return to beta ratio. Find out the Cut-off point- to know the likely security to be figured in optimal portfolio.

Determine the proportion to be invested in particular security. MODELS USED IN PORTFOLIO SELECTION Utility models Geometric Mean model Safety First model Stochastic Dominance Model

PORTFOLIO REVISION It is necessary and highly beneficial to investors to have constant monitoring of the portfolio and to make necessary amendments in timely manner to ensure best possible return and at the same time it is helpful at times in minimizing risk. Thus, portfolio revision is necessary considering high volatility in the market. There are many factors which affect the investors which make portfolio revision and up gradation necessary. This step not only ensures investors wealth maximization but at times helps him to minimize the losses due to high volatility observed in the market Change in wealth Change in time horizon Changes in liquidity needs Changes in taxes Bull and Bear markets Inflation rate changes Changing return prospects

PORTFOLIO REVISION TECHNIQUES Constant Dollar Value Plan Constant Ratio Plan Variable Ratio Plan

Generally risk level observed in emerging markets is far higher compared to developed markets. The situation prevailing in emerging markets are highly volatile which demands constant monitoring of the portfolio and up gradation in portfolio from time to time.

EMERGING MARKET v/s DEVELOPED MARKETS There is vast difference between the emerging markets and developed markets. Emerging are the growing markets which are new and has the potential to perform well. Naturally while designing portfolio it needs to be considered the market in which the portfolio is designed. The risk level would be far higher in emerging markets compared to the developed markets. The portfolio selection and revision techniques which are followed become more prominent with respect to emerging markets than the developed markets. Also, such techniques are to be followed on the continual basis when the investors portfolio is designed with respect to emerging markets. Emerging market tend to exhibit cyclical market behaviour due to interest rate differentials with foreign currencies. They often appreciate steadily during normal market conditions but depreciate violently in times of crisis as investors retreat to the safe haven of low-yielding currencies. High volatility and the unfavourable interest rate differential means currency risk hedging can be costly. Given the poor average performance of such hedges, many corporates question their long-term benefit. The emerging markets possess high level of risk due to volatility observed so such tech

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