project on portfolio cunstrection

7/30/2019 Project on Portfolio Cunstrection

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PORTFOLIO CUNSTRECTION

SURANA PG CENTER Page 1

CHAPTER 1

INTRODUCTION

Portfolio construction

The field of investment is traditionally divided into security analysis and portfolio

management. The heart of security analysis is valuation of financial assets. Value in turn is

the function of risk and return. These two concepts are in the study of investment .Investment

can be defined as the commitment of funds to one or more assets that will be held over for

some future time period.

Portfolio Management Services (PMS) is an investment portfolio in stocks, fixed income,

debt, cash, structured products and other individual securities, managed by a professional

fund manager that can potentially be tailored to meet specific investment objectives.

When you invest in PMS, you own individual securities unlike a mutual fund investor, who

owns units of the entire fund. You have the freedom and flexibility to tailor your portfolio to

address personal preferences and financial goals. Although portfolio managers may oversee

hundreds of portfolio, your account may be unique.

Steps to Stock selection process

Choosing Investments

Fundamental Analysis

Interactive Charting Tool

Stock Market Sectors

Sector Rotation

Growth vs. Value

GARP
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Choosing Investments

Many new investors believe there is some secret strategy which will guarantee success, but

unfortunately there is no such magic formula, and stock selection is just another importantpiece to help build your portfolio.

With the wide array of investment solutions available, it can be challenging to know which

investments are best suited to meet your needs. To simplify the selection process, many

investors choose stocks based solely on performance. While performance is significant,

other important factors should be considered as well.

Fundamental Analysis

Fundamental analysis, which some would argue is the most important step in investing,

focuses on studying a companys financial statements. This method is also known as

quantitative analysis and involves looking at revenue, expenses, assets, liabilities and all

the other financial aspects of a company.

Fundamental analysts and investors evaluate a security by attempting to measure a

companysintrinsic value. After studying the economic, financial, qualitative and

quantitative factors, an investor tries to figure out what the company is actually worth in

order to determine what sort of position to take in that companys stock. For instance, if

the fundamental investor determines that the stock is actually worth more than it is trading

for, they would buy the stock because it appears to be under-priced, or in other words, the

market has not fully realized and reflected the stocks actual worth. Alternatively, if after

analyzing a stock, the investor determines that the stocks intrinsic value is actually less

than its currentmarket price, the investor would likely sell the stock.

Interactive Charting Tool

The advanced interactive chart tool can assist you in performing technical analysis. Results

are presented in an easy-to-understand format that will help you identify historical trends

or patterns.
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Stock Market Sectors

Asectorrefers to a group of stocks representing companies in a similar line of business or

industry. All of the stocks on the S&P TSX can be broken down into 10 differentcategories (sectors) based on their line of business or industry.

Sector Rotation

Sector rotation is an investment strategy that consists of moving money from one industry

sector to another in an attempt to beat the market. At different stages in an economy, an

investor or portfolio manager may choose to shift investment assets from one investment

sector to another, based on the currentbusiness cycle(since different sectors are stronger at

different points in the business cycle).

Growth vs. Value

Growth and value investing are two very different investment strategies. Value investors

look for stocks that are trading for less than their apparent worth. They are concerned with

the present. However growth investors are much more focused on the future potential of a

company, and are less focused on the present price. If a growth investor finds a stock that

is trading for more than itsintrinsic value, they believe that the companies' intrinsic worth

will grow to exceed their current valuations.

GARP

If youve read through theGrowth vs. Valueinvesting section and find your own style is

somewhere in between, then maybe GARP is the right solution for you.

GARP stands for Growth at a Reasonable Price and is really a combination of value and

growth investing. GARP investors are looking for a stock that is slightly under-valued with

earnings growth potential. GARP investors do not necessarily abide by specific rations or

valuation metrics to help them make stock selections. That being said, GARP investors

usually do follow P/E valuations.
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PORTFOLIO:

In todays financial market place, a well-maintained portfolio is vital to any investors

success. As an individual investor, you need to know how to determine an asset allocation

that best conforms to your personal investment goals and strategies. In other words, your

portfolio should meet your portfolio should meet your future needs for capital and give you

peace of mind. Investors can construct portfolio aligned to their goals and investment

strategies by following a systematic approach. Here we go over some essential steps for

taking such an approach.

It is combination of all the securities, group of assets-such as stocks, bonds and mutual funds

held by an investor. It is constructed in such a manner to meet the investors goals andobjectives. The balanced portfolio is the one which gives maximum return with minimum

risk.

Diversification of investment helps to spread risk over many assets. A diversification of

securities gives the assurance of obtaining the anticipated return on the portfolio, same

securities may not perform as expected, but others may exceed the expectation and making

the actual return of the portfolio reasonably close to the anticipated one. Keeping a portfolio

of single security may lead to a greater likelihood of the actual return somewhat different

from that of the expected return.

To reduce their risk, investors tend to hold more than just a single stock or other asset. Each

piece of the portfolio is divided up into specific assets such as bonds, equities, stock, mutual

funds etc. A passive form portfolio management involves the matching of future cash flows

with future liabilities.


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PORTFOLIO CONSTRUCTION:

Portfolio is a combination of securities such as stocks, bonds and money market instrument.

The process of blending together the broad asset classes so as to obtain optimum return with

minimum risk return is called Portfolio Construction.

Portfolio management concerns the construction and maintenance of a collection of

investment. It is investment of funds in different securities in which the total risk of the

portfolio is minimized. It primarily involves reducing risks rather that increasing return.

Return is obviously important through and the ultimate objective of portfolio manager is to

achieve a chosen level of return by incurring the least possible risk.

Investing in securities such as shares, debentures and bonds is profitable as well as exciting.

It indeed it involves a great deal of risk. It is rare to find investors investing their entire

savings in a single security. Instead they tend to invest in a group of securities. Such group of

securities is called a Portfolio Creation of a Portfolio helps to reduce risks without sacrificing

returns. The Portfolio should be constructed in such a way that it should give an investor

maximum return with minimum risk.

A good portfolio should have multiple objectives and achieve a sound balance among them.

Any one objective should not be given undue important at the cost of others.

OBJECTIVES:

Safety of the Investment.

Stable Current Returns.

Appreciation in the value of capital.

Marketability, liquidity.


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TYPES OF PORTFOLIOS

The different types of Portfolio which is carried by any Fund Manager to maximize profit and

minimize losses are different as per their objectives. They are as follows:

Aggressive Portfolio:

Objective: Growth. This strategy might be appropriate for investors who seek high growth

and who can tolerate wide fluctuations in market values, over the short term.

Growth Portfolio:

Objective: Growth. This strategy might be appropriate for investors who have a preference

for growth and who can withstand significant fluctuations in market values.


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Balanced Portfolio:

Objective: Capital appreciation and income. This strategy might be appropriate for investors

who want the potential for capital appreciation and some growth, and who can withstand

moderate fluctuations in market values.

Conservative Portfolio:

Objective: Income and capital appreciation. This strategy may be appropriate for investors

who want to preserve their capital and minimize fluctuations in marketvalue.

Investment management solution in PMS can be provided in the following ways:

i. Discretionary

ii. Non-Discretionary

iii. Advisory


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Discretionary: Under these services, the choice as well as the timings of the investment

decisions rest solely with the Portfolio Manager.

Non-Discretionary: Under these services, the portfolio manager only suggests the

investment ideas. The choice as well as the timings of the investment decisions rest solely

with the Investor. However the execution of trade is done by the portfolio manager.

Advisory:Under these services, the portfolio manager only suggests the investment ideas.

The choice as well as the execution of the investment decisions rest solely with the Investor.

Rule 2, clause (d) of the SEBI (portfolio managers) Rules, 1993 defines the term Portfolio

as total holding of securities belonging to any person.

The Portfolio Construction of rational investors wishes to maximize the returns on their funds

for a given level of risk. All investments possess varying degrees of risk. Returns come in the

form of income, such as interest or dividends, or through growth in capital values (i.e. capital

gains).

The portfolio construction process can be broadly characterized as comprising the following

steps:

1. Setting objectives.

The first step in building a portfolio is to determine the main objectives of the fund given the

constraints (i.e. tax and liquidity requirements) that may apply. Each investor has different

objectives, time horizons and attitude towards risk. Pension funds have long-term obligations

and, as a result, invest for the long term. Their objective may be to maximize total returns in

excess of the inflation rate. A charity might wish to generate the highest level of income

whilst maintaining the value of its capital received from bequests. An individual may have

certain liabilities and wish to match them at a future date. Assessing a clients risk tolerance

can be difficult. The concepts of efficient portfolios and diversification must also be

considered when setting up the investment objectives.


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2.Defining Policy.

Once the objectives have been set, a suitable investment policy must be established. The

standard procedure is for the money manager to ask clients to select their preferred mix of

assets, for example equities and bonds, to provide an idea of the normal mix desired. Clients

are then asked to specify limits or maximum and minimum amounts they will allow to be

invested in the different assets available. The main asset classes are cash, equities, gilts/bonds

and other debt instruments, derivatives, property and overseas assets. Alternative

investments, such as private equity, are also growing in popularity, and will be discussed in a

later chapter. Attaining the optimal asset mix over time is one of the key factors of successful

investing.

3.Applying portfolio strategy.

At either end of the portfolio management spectrum of strategies are active and passive

strategies. An active strategy involves predicting trends and changing expectations about the

likely future performance of the various asset classes and actively dealing in and out of

investments to seek a better performance.

For example, if the manager expects interest rates to rise, bond prices are likely to fall and so

bonds should be sold, unless this expectation is already factored into bond prices. At this

stage, the active fund manager should also determine the style of the portfolio. A passive

strategy usually involves buying securities to match a preselected market index.

Alternatively; a portfolio can be set up to match the investors choice of tailor-made index.

Passive strategies rely on diversification to reduce risk. Outperformance versus the chosen

index is not expected. This strategy requires minimum input from the portfolio manager. In

practice, many active funds are managed somewhere between the active and passive

extremes, the core holdings of the fund being passively managed and the balance being

actively managed.


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4.Asset selections.

Once the strategy is decided, the fund manager must select individual assets in which to

invest. Usually a systematic procedure known as an investment process is established, which

sets guidelines or criteria for asset selection. Active strategies require that the fund managers

apply analytical skills and judgment for asset selection in order to identify undervalued assets

and to try to generate superior performance.

5.Performance assessments.

In order to assess the success of the fund manager, the performance of the fund is periodically

measured against a pre-agreed benchmark perhaps a suitable stock exchange index or

against a group of similar portfolios (peer group comparison). The portfolio construction

process is continuously iterative, reflecting changes internally and externally. For example,

expected movements in exchange rates may make overseas investment more attractive,

leading to changes in asset allocation. Or, if many large-scale investors simultaneously decide

to switch from passive to more active strategies, pressure will be put on the fund managers to

offer more active funds. Poor performance of a fund may lead to modifications in individual

asset holdings or, as an extreme measure; the manager of the fund may be changed

altogether.


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CHAPTER 2

REVIEW OF LITERATURE & RESEARCH DESIGN

Introduction

In the booming world of economy, everyone wants to use their money to earn more money.

People today are looking forward to invest in the Stock Market which at is one of the most

preferable source and place of investment. But many of them though have a huge amount of

money in hand at disposal, find it very difficult to invest due to lack of knowledge about the

stock market. So, the study is done on the 20 stocks under nifty so as to construct an optimal

portfolio for these investors. The need for the study includes:

Understanding about the stock market and its trend and knowing the performance and

fluctuations in the share prices by analysing the risk and return on securities.

Constructing an optimal investment portfolio and helping the investors for investing

in securities as per their needs and risk appetite.

Providing investment advice as per their risk appetite and the long and short term

financial requirements (which would need analysing products that suits for short term

financial goal and long term as well)

For the research study, several literature works has been referred to. Very few of them

have been mentioned here like-


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Sharpe, William F.

(1966) suggested a measure for the evaluation of portfolio performance. Drawing on results

obtained in the field of portfolio analysis, economist Jack L. Treynor has suggested a new

predictor of mutual fund performance, one that differs from virtually all those used

previously by incorporating the volatility of a fund's return in a simple yet meaningful

manner.

Michael C. Jensen

(1967) derived a risk-adjusted measure of portfolio performance (Jensens alpha) that

estimates how much a managers forecasting ability contributes to funds returns. As

indicated by Statman (2000), the e SDAR of a fund portfolio is the excess return of the

portfolio over the return of the benchmark index, where the portfolio is leveraged to have the

benchmarkindexs standard deviation.

S.Narayan Rao,

evaluated performance of Indian mutual funds in a bear market through relative performance

index, risk-return analysis, Treynors ratio, Sharpes ratio, Sharpes measure , Jensens

measure, and Fames measure.

K. Pendaraki

studied construction of mutual fund portfolios, developed a multi-criteria methodology and

applied it to the Greek market of equity mutual funds. T h e methodology is based on the

combination of discrete and continuous multi-criteria decision aid methods for mutual fund

selection and composition. UTADIS multi-criteria decision aid methodises employed in order

to develop mutual funds performance models. Goal programming model is employed to

determine proportion of selected mutual funds in the final portfolios.

Zakri Y.Bello

(2005) matched a sample of socially responsible stock mutual funds matched to randomly

select conventional funds of similar net assets to investigate differences in characteristics of

assets held, degree of portfolio diversification and variable effects of diversification oninvestment performance. The study found that socially responsible funds do not differ


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significantly from conventional funds in terms of any of these attributes. Moreover, the effect

of diversification on investment performance is not different between the two groups. Both

groups underperformed the Domini 400 Social Index and S & P 500 during the study period.

Research Paper Number 120

Omega Portfolio Construction with Johnson Distributions

Author:

Alexander PASSOW - Gottex Fund Management and FAME

Date:

November 2004

This paper has now been published and is no longer available as a part of our Research PaperSeries. The published text can be found with the following reference:

Alexander Passow "Omega Portfolio Construction with Johnson Distributions" Risk, April

2005, vol. 18, Issue 4.

Abstract:

The omega risk-adjusted performance measure with Johnson distributions accounts

comprehensively and non-discretionarily for the first potentially persistent moments

including

skewness and kurtosis. The Johnson-omega ratio thus overcomes the shortcomings of other

measures and is inherently less sensitive to input data noise and to changes of the threshold

than

empirical omega. Alexander Passow derives an explicit representation of the Johnson-omega

ratio that was successfully tested in a hedge fund portfolio optimization framework using

both

historical and forward-looking performances of individual indexes.

Statement of the problem:

The Indian Stock Market is very volatile and unpredictable in nature. The investors though

have many fail to earn good returns and choose the securities with lesser risk, because of their

ignorance and lack of knowledge about the stock market and its volatility.


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Scope of the Study:

The scope of study is limited to collecting the data published in the reports of the company

and NSE website and theoretical frame work of the data with a view to suggest solutions tovarious problems relating to portfolio construction. The study includes study of only NSE

NIFTY, not whole Equity markets. The other asset classes are also not included in

preparation of portfolio. The study however covers information related to the Equity fund and

the portfolio management and:

Analysis of investors risk involved in the investment in various securities.

Identification of the investors objectives, constraints and preferences.

Development of strategies in tune with investment policy formulated.

To reduce the future risk in advance.

To earn maximum profit from the investment in the securities.


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Objectives of the Study:

Each research study has its own specific purpose. And the main objective of this project is

basically to construct an optimal portfolio for the investors so as to put their idle money intoan investment portfolio which would give in turn a good return to them with minimum risk

involved.

However the other objectives would consist:

To learn about the Indian stock market and observe the market trend.

To understand the investors need and their expected return on the investment.

To ascertain the investors risk bearing capacity.

To study the risk return volatility of the different products.

To construct an optimal portfolio for the investors which would give an optimum

return with least risk involved.

To suggest measures for the customers in deciding and choosing the optimal securities

by creating awareness about the performance and risk-return of various stocks.


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Hypothesis:

A hypothesis is a proposed explanation for a phenomenon. The term derives from the Greek,

hyposthenia meaning "to put under" or "to suppose".

H0there is no option to get best return

H1there is an option to get best return

Research Design:

The project report is based on both primary and secondary data. However, though the primary

data was a basis for the research to find out the investors need, their risk appetite and their

expectation from the investment, the secondary data is given more importance for it was the

source for constructing an optimal portfolio for the investors which is the main problem in

the study.

The Research design used for the study is Analytical or Exploratory Research Design for

which the data used are the secondary data. However, to carry out this research on the

secondary data, the basis was on the descriptive study done by use of primary data collected

through the Questionnaire distributed to the investors.

Secondary data: Other materials like Reference books, Journals, magazine, internal guide

and External guide information.


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Plan of Analysis:

Firstly the portfolio is constructed on the basis of current budget. In this year budget more

importance is given to the infrastructure , banks , cements, and which are supportingindustries for infrastructure, so I have picked on those sector of about 50 companies and

taking the one year traded price of those companies and indices of NSE calculated the

returns, variances, standard deviation and beta and if there is an higher returns and higher

standard deviation it is taken into aggressive and if there is an moderate risk and return it is

taken in to moderate portfolio and if there is a low risk and good return it is putted in the

conservative portfolio and then after grouping, calculatethe cutoff point. on the basis of cut

off point the weight age is given to each script and on that probability amount is divided and

portfolio return and portfolio beta is calculated.

Limitation:

Stock market is always subject to market risk.

Indian stock market is dominated by FIIs (Foreign Institutional Investors), so

volatility is more and we cannot predict the market.

Greed in people


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Tools and techniques of Analysis:

RETURNS:

Returnis used to select scrips for portfolio which is calculated by using the previous one year

data. Return on investment/asset for given period, say a year, consists of annual income

(dividend) receivable plus change in market price.

Rate of Return = Todaysprice-yesterdays price *100

Yesterdays price

STANDARD DEVIATION:

Standard deviation has been used as a proxy measure for risk of a security. It measures the

fluctuations around mean returns. It equals to the positive square root of variance. The

smaller the standard deviation, the lower is the risk of the investment.

Standard deviation= = = ( ) Where,

X = Return of the scrips.

X = Mean or the average of the returns.

N = Number of Days.


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BETA:

The market, or systematic, risk can be measured by comparing the return on an investment

with the return on the market in general, or an average stock; the resulting measure is called

the beta coefficient, and is identified using the Greek symbol . It gives an indication of the

degree of movement in returns associated with an investment relative to the market, which

contains only systematic risk. The beta for market portfolio is equal to one by definition.

= ()

Where,

X = Index return.

Y= Stock return.

N = Number of Days.

BETA:

Beta is the slope of the characteristics regression line. The beta value describes relationshipbetween the stocks return and the index returns.

Beta = +1

One percent change in market index causes exactly one percent change in the stock return

indicates that the stock moves in tandem in market.

Beta = +0.5

One percent changes in market index causes exactly 0.5 percent changes in the stock return.

The stock is less volatile compared to the market.

Beta = +2

One percent changes in market index causes exactly 2 percent changes in the stock return.

The stock is more volatile. When there is a decline in the market return, the stock return with

beta of 2 would give a negative return of 20 percent. The stocks with more than 1 beta value

are considered to be risky.


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SYSTEMATIC RISK AND UNSYSTEMATIC RISK

SYSTEMATIC RISK:-

Systematic risk refers to that portion of total risk which arises on account of factors that affect

the price of all the securities in the general .Economic, political and sociological changes are

the principal sources of the systematic risk. these factors have a bearing on the performance

of companies and thereby on their share prices. The individual security prices tend to move

together with the changes in the market. For example, when the economy is moving towards

a recession, the corporate profits will decline and the share prices of almost all the companies

may decline. Systematic risk cannot be reduced through diversification.Sys risk=beta

square*market variance. Sys risk is subdivided is to 3 types

Market risk

Interest risk

Purchasing power risk

UNSYSTEMATIC RISK:-

Unsystematic risk refers to that portion of total risk which arises on account of factor thataffects the prices of the securities of a specific company. It is unique and peculiar to a

specific firm or industry. It is also known as unique risk. Unsystematic risk come from

managerial inefficiency, change in consumer preferences, technological changes etc.

Two subdivisions are

1. Business risk

2. Financial risk


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Business Risk

Business risk is that portion of the unsystematic risk caused by the operating environment of

the business.

Business risk arises from the inability of a firm to maintain its competitive edge and the

growth or stability of (fie earnings. Variation that occurs in the operating environment is

reflected on the operating income and expected dividends. The variation in the expected

operating income indicates the business risk. For example take Abc and xyz companies. In

Abc company, operating income could grow as much as IS per cent and as low as 7 per cent.

In xyz Company, the operating income can be either 12 per cent or 9 per cent. When both the

companies are compared, Abc Companys business risk is higher because of its high

variability in operating income compared to xyz Company. Thus, business risk is concerned

with the difference between revenue and earnings before interest and tax. Business risk can

be divided into external business risk and internal business risk.

Internal Business Risk

Internal business risk is associated with the operational efficiency of the firm. The operational

efficiency differs from company to company. The efficiency of operation is reflected on the

company's achievement of its pre-set goals and the fulfilment of the promises to its investors.

(1) Fluctuations in the sales the sales level has to be maintained. It is common in business to

lose customers abruptly because of competition. Loss of customers will lead to a loss in

operational income. Hence, the company has to build a wide customer base through various

distribution channels. Diversified sales force may help to tide over this problem. Big

corporate bodies have long chain of distribution channel. Small firms often lack this

diversified customer base.


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(2) Research and development (R&D) Sometimes the product may go out of style or

become obsolescent. It is the management, who has to overcome the problem of obsolescence

by concentrating on the in-house research and development program. For example, if Maruti

Udyog has to survive the competition, it has to keep its Research and Development section

active and introduce consumer oriented technological changes in the automobile sector. This

is often carried out by introducing sleekness, seating comfort and break efficiency in their

automobiles. New products have to be produced to replace the old one. Short sighted cutting

of R and D budget would reduce the operational efficiency of any firm.

(3) Personnel management The personnel management of the company also contributes to

the operational efficiency of the firm. Frequent strikes and lock outs result in loss of

production and high fixed capital cost. The labor productivity also would suffer. The risk of

labor management is present in all the firms. It is up to the company to solve the problems at

the table level and provide adequate incentives to encourage the increase in labor

productivity. Encouragement given to the laborers at the floor level would boost morale of

the labor force and leads to higher productivity and less wastage of raw materials and time.

(4) Fixed cost The cost components also generate internal risk if the fixed cost is higher in

the cost component. During the period of recession or low demand for product, the companycannot reduce the fixed cost. At the same time in the boom period also the fixed factor cannot

vary immediately. Thus, the high fixed cost component in a firm would become a burden to

the firm. The fixed cost component has to be kept always in a reasonable size, so that it may

not affect the profitability of the company.

(5) Single product The internal business risk is higher in the case of firm producing a single

product. The fall in the demand for a single product would be fatal for the firm. Further, some

products are more vulnerable to the business cycle while some products resist and grow

against the tide. Hence, the company has to diversify the products if it has to face the

competition and the business cycle successfully. Take for instance, Hindustan Lever Ltd.,

which is producing a wide range of consumer cosmetics is thriving successfully in the

business. Even in diversification, diversifying the product in the unknown path of the

company may lead to an internal risk. Unwieldy diversification is as dangerous as producing

a single good.


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External Risk

External risk is the result of operating conditions imposed on the firm by circumstances

beyond its control. The external environments in which it operates exert some pressure on the

firm. The external factors are social and regulatory factors, monetary and fiscal policies of the

government, business cycle and the general economic environment within which a firm or an

industry operates. A government policy that favors a particular industry could result in the

rise in the stock price of the particular industry. For instance, the Indian sugar and fertilizer

industry depend much on external factors.

1. Social and regulatory factors Harsh regulatory climate and legislation against the

environmental degradation may impair the profitability of the industry. Price control, volume

control, import/export control and environment control reduce the profitability of the firm.

This risk is more in industries related to public utility sectors such as telecom, banking and

transportation. The governments' tariff policy of the telecom sector has a direct bearing on its

earnings. Likewise, the interest rates and the directions given in the lending policies affect the

profitability of the banks. CESC has not been able to increase its power tariff due to the stiff

resistance by the West Bengal government.

The Pollution Control Board has asked to close most of the tanneries in Tamil Nadu, which

has affected the leather industry.

2. Political risk Political risk arises out of the change in the government policy. With a

change in the ruling party, the policy also changes. When Sri. Manmohan Singh was the

finance minister, liberalization policy was introduced. During the Bharathiya Janata

government, even though efforts are taken to augment the foreign investment, more stress is

given to Swadeshi. Political risk arises mainly in the case of foreign investment. The hostgovernment may change its rules and regulations regarding the foreign investment. From the

past, an example can be cited. In 1977, the government decided that the multinationals must

dilute their equity and share their growth with the Indian investors. This forced many

multinationals to liquidate their holdings in the Indian companies.


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3. Business cycle The fluctuations of the business cycle lead to fluctuations in the earnings of

the company. Recession in the economy leads to a drop in the output of many industries.

Steel and white consumer goods industries tend to move in tandem with the business cycle.

During the boom period, there would be hectic demand for steel products and white

consumer goods. But at the same time, they would be hit much during the recession period.

At present, the information technology industry has resisted the business cycle and moved

counter cyclically during the recession period. The effects of the business cycle vary from

one company to another. Sometimes, companies with inadequate capital and consumer base

may be forced to close down. In some other case, there may be a fall in the profit and the

growth rate may decline. This risk factor is external to the corporate bodies and they may not

be able to control it.

Financial Risk

It refers to the variability of the income to the equity capital due to the debt capital. Financial

risk in a company is associated with the capital structure of the company. Capital structure of

the company consists of equity funds and borrowed funds. The presence of debt and

preference capital results in a commitment of paying interest or pre fixed rate of dividend.

The residual income alone would be available to the equity holders. The interest payment

affects the payments that are due to the equity investors. The debt financing increases the

variability of the returns to the common stock holders and affects their expectations regarding

the return. The use of debt with the owned funds to increase the return to the shareholders is

known as financial leverage.

Debt financing enables the corporate to have funds at a low cost and financial leverage to the

shareholders. As long as the earnings of a company are higher than the cost of borrowed

funds, shareholders' earnings are increased. At the same time when the earnings are low, it

may lead to bankruptcy to equity holders.


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The financial risk considers the difference between EBIT and EBT (earnings before tax). The

business risk causes the variations between revenue and EBIT. The payment of interest

affects the eventual earnings of the company stock. Thus, volatility in the rates of return on

the stock is magnified by the borrowed money. The variations in income caused by .the

borrowed funds in highly levered firms are greater compared to the companies with low-

leverage. The financial leverage or financial risk is an avoidable risk because it is the

management who has to decide, how much to be funded with the equity capital and borrowed

capital

MINIMISING RISK EXPOSURE

Every investor wants to guard himself from the risk. This can be done by understanding the

nature of the risk and careful planning. The following paragraphs give an agenda for

protecting the investors from the different types of risks,

Market Risk Protection

1. The investor has to study the price behavior of the stock. Usually history repeats itself even

though it is not in perfect form. The stock that shows a growth pattern may continue to do so

for some more periods. The Indian stock market expects the growth pattern to continue for

some more time in information technology stock and depressing conditions to continue in the

textile related stock. Some stocks may be cyclical stocks. It is better to avoid such type of

stocks.

2. The standard deviation and beta indicate the volatility of the stock. The standard deviation

and beta are available for the stocks 'that are included in the indices. The National Stock

Exchange News bulletin provides this information. Looking at the beta values, the investor

can gauge the risk factor and make wise decision according to his risk tolerance.

3. Further, the investor should be prepared to hold the stock for a period of time to reap the

benefits of the rising trends in the market. He should be careful in the timings of the purchase

and sale of the stock. He should purchase it at the lower level and should exit at a higher level


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Protection against Interest Rate Risk

1. Often suggested solution for this is to hold the investment to maturity. If he sells it in the

middle due to fall in the interest rate, the capital invested would experience a heavy loss.

2. The investors can also buy treasury bills and bonds of short maturity. The portfolio manager

can invest in the treasury bills and the money can be reinvested in the market to suit the

prevailing interest rate.

Protection against Inflation

1. The general opinion is that the bonds or debentures with fixed return cannot solve the

problem. If the bond yield is 13 to 15 per cent with low risk factor, they would provide hedge

against the inflation.

2. Another way to avoid the risk is to have investment in short term securities and to avoid long

term investment. The rising consumer price index may wipe off the real rate of interest in the

long term.

3. Investment diversification can also solve this problem to a certain extent. The investor has to

diversify his investment in real estates, precious metals, arts and antiques along with the

investment in securities. One cannot assure that different types of investments would provide

a perfect hedge against inflation. It can rninimise the loss due to the fall in the purchasing

power.


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Protection against Business and Financial Risk

1. To guard against the business risk, the investor has to analyze the strength and weakness of

the industry to which the company belongs. If weakness of the industry is too much ofgovernment interference in the way of rules and regulations, it is better to avoid it.

2. Analyzing the profitability trend of the company is essential. The calculation of standard

deviation would yield the variability of the return. If there is inconsistency in the earnings, it

is better to avoid it. The investor has to choose a stock consistent track record.

3. The financial risk should be minimized by analyzing the capital structure of the company. If

the debt equity ratio is higher, the investor should have a sense of caution. Along with thecapital structure analysis, he should also take into account of the interest payment. In a boom

period, the investor can select a highly levered company but not in a recession.

RISK MEASUREMENT

Understanding the nature of the risk is not adequate unless the investor or analyst is capable

of expressing it in some quantitative terms. Expressing the risk of a stock in quantitative

terms makes it comparable with other stocks. Measurements cannot be assured of cent percent accuracy because risk is caused by numerous factors such as social, political, economic

and managerial efficiency. Measurement provides an approximate quantification of risk. The

statistical tool often used to measure and used as a proxy for risk is the standard deviation.

Standard Deviation

It is a measure of the values of the variables around its mean or it is the square root of the

sum of the squared deviations from the mean divided by the number of observances. The

arithmetic mean of the returns may be same for two companies but the returns may vary

widely.


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INDUSTRY PROFILE

The stock market

With over 20 million shareholders, India has the third largest investor base in the

world after the USA and Japan. Over 9,000 companies are listed on the stock exchanges,

which are serviced by approximately 7,500 stockbrokers. The Indian capital market is

significant in terms of the degree of development, volume of trading and its tremendous

growth potential.

There are 23 recognized stock exchanges in India, including the Over the Counter

Exchange of India (OTCEI) for small and new companies and the National Stock Exchange

(NSE) which was set up as a model exchange to provide nation-wide services to investors.

NSE, which in the recent past has accounted for the largest trading volumes, has a fully

automated screen based system that operates in the wholesale debt market segment as well as

the capital market segment.

India's market capitalization was amongst the highest among the emerging markets.

Total market capitalization of the BSE as on July 31, 1997 was Rs 5,573.07 billion growing

by 18 percent over a period of twelve months and as of August 2005 was over $500 billion(about Rs 22 lakh crores).A stock exchange in India operates with due recognition from the

government under the securities and contracts (Regulations) Act, 1956. The member brokers

are essentially the middlemen, who transact in securities on behalf of the public for a

commission or on their own behalf.

The stock market is typically governed by a board consisting of directors, a majority

of whom are elected by the member brokers. The other members of board are nominated by

the government. Government nominees include representatives of the Ministry of finance, as

well as some public representative, who are expected to safeguard the interest on investors in

the functioning of exchanges. The board is headed by a president, who is an elected member,

usually nominated by the government, from among the elected members. The Executive

Director, who is appointed by the stock exchange with government approval, is the

operational chief of the stock exchange are carried out in accordance with the rules and

regulations governing its functioning.

India stock exchanges


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The working of stock exchanges in India started in 1875. BSE is the oldest stock market in

India. The history of India stock trading starts with 318 persons taking membership in Native

share and Stock Brokers Association, which we know by the name Bombay Stock Exchange

or BSE in short. In 1965, BSE got permanent recognition from the Government of India.

BSE and NSE represent themselves as synonyms of India stock market. The history of India

stock market is almost the same as the history of BSE.

BSE-Bombay Stock Exchange

SENSEX - THE BAROMETER OF INDIAN CAPITAL MARKETS

The Bombay Stock Exchange, is the oldest stock exchange in Asia, was established in 1875

as the Native Share and Stock Brokers Association at Dalal Street in Mumbai. In 1956, the

BSE obtained recognition from the Government of India- the first stock exchange to do so

under the Securities Contracts (Regulation) Act, 1956.

The Sensex, first compiled in 1986, is a Market Capitalization- Weighted Index of 30

component stocks representing a sample of large and financially sound companies. The BSE-

Sensex is the benchmark index of the Indian capital markets.

The 30 stock sensitive index or Sensex was first compiled in 1986. The Sensex is compiled

based on the performance of the stocks of 30 financially sound benchmark companies. In

1990 the BSE crossed the 1000 mark for the first time. It crossed 2000, 3000 and 4000

figures in 1992. The reason for such huge surge in the stock market was the liberal financial

policies announced by the then financial minister Pranab mukarje. Sensex crossed the 5000

mark in 1999 and the 6000 mark in 2000. The 7000 mark was crossed in June and the 8000

in September likewise it almost reached 14500 in the month of January 2007. Many Foreign

institutional investors (FII) are investing in Indian, markets on a large scale.

The BSE Sensex comprises these 30 stocks: ACC, Bajaj Auto, Bharti Tele, BHEL, Cipla, Dr

Reddys, Gujarat Ambuja, Grasim, HDFC, HDFC Bank, Hero Honda, Hindalco, HLL, ICICI

Bank, Infosys, ITC, L&T, Maruti, NTPC, ONGC, Ranbaxy, Reliance, Reliance Energy,

Satyam, SBI, Tata Motors, Tata Power, TCS and Wipro. Heres a timeline on the rise of the

SENSEX through Indian stock market history
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National stock exchange

Based on the recommendations by High Powered Study Group on established on New Stock

Exchanges, NSE was promoted by leading Financial Institutions at the behest of the

Government of India and was incorporated in November 1992 as a tax-paying company

unlike other stock exchanges in the country.

On its recognition as a stock exchange under the securities contracts (Regulation) Act, 1956

in April 1993, NSE commenced operations in the Wholesale Debt market (WDM) segment in

June 1994. The capital market (Equities) segment commenced operations in November 1994

and operations in Derivatives segment commenced in June 2000.

NIFTY:

The Nifty is relatively a new comer in the Indian market. S&P CNX Nifty is a 50 stock index

accounting for 23 sectors of the economy. It is used for purposes such as benchmarking fund

portfolios, index based derivatives and index funds.

The base period selected for Nifty is the close of prices on November 3, 1995, which marked

the completion of one-year of operations of NSEs capital market segment. The base value of

index was set at 1000.

S&P CNX Nifty is owned and managed by India Index Services and Products Ltd. (IISL),

which is a joint venture between NSE and CRISIL. IISL is a specialized company focused

upon the index as a core product. IISL have a consulting and licensing agreement with

Standard & Poors (S&P), who are world leaders in index services.

ral requirements under the Companies Act have been dispensed with. Two depositories, viz.,NSDL and CDSL, have come up to provide instantaneous electronic transfer of securities.

Players (investors) in securities market

Individual investors

Institutional investors

FIIs

Mutual fund investor
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COMPANY PROFILE

BACKGROUND OF THE COMPANY

HISTORY OF INDIA INFOLINE LTD

We were originally incorporated on October 18, 1995 as Probity Research and Services

Private Limited at Mumbai under the Companies Act, 1956 with Registration No. 11 93797.

We commenced our operations as an independent provider of information, analysis and

research covering Indian businesses, financial markets and economy, to institutional

customers. We became a public limited company on April 28, 2000 and the name of the

Company was changed to Probity Research and Services Limited. The name of the Company

was changed to India Infoline.com Limited on May 23, 2000 and later to India Infoline

Limited on March 23, 2001.

In 1999, we identified the potential of the Internet to cater to a mass retail segment and

transformed our business model from providing information services to institutional

customers to retail customers.

Hence we launched our Internet portal, www.indiainfoline.com in May 1999 and started

providing news and market information, independent research, interviews with business

leaders and other specialized

features.

In May 2000, the name of our Company was changed to India

Infoline.com Limited to reflect the transformation of our business. Over a period of time, we

have emerged as one of the leading business and financial information services provider in

India.

In the year 2000, we leveraged our position as a provider of financial information and

analysis by diversifying into transactional services, primarily for online trading in shares and

securities and online as well as offline distribution of personal financial products, like mutual

funds and RBI Bonds. These activities were carried on by our wholly owned subsidiaries.


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Our broking services was launched under the brand name of 5paisa.com through our

subsidiary, India Infoline Securities Private Limited and www.5paisa.com, the e-broking

portal, was launched for online trading in July 2000. It combined competitive brokerage rates

and research, supported by Internet technology Besides investment advice from an

experienced team of research analysts, we also offer real time stock quotes, market news and

price charts with multiple tools for technical analysis.

Acquisition of Agri Marketing Services Limited (Agri)

In March 2000, we acquired 100% of the equity shares of Agri Marketing

Services Limited, from their owners in exchange for the issuance of 508,482 of our equityshares. Agri was a direct selling agent of personal financial products including mutual funds,

fixed deposits, corporate bonds and post-office instruments. At the time of our acquisition,

Agri operated 32 branches in South and West India serving more than 30,000 customers with

a staff of, approximately 180 employees. After the acquisition, we changed the company

name to India Infoline.com Distribution Company Limited.


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History & Milestones

2011

Launched IIFL Mutual Fund.

2010

Received in-principle approval for membership of the Singapore

Stock Exchange

Received membership of the Colombo Stock Exchange

2009

Acquired registration for Housing Finance

SEBI in-principle approval for Mutual Fund

Obtained Venture Capital license

2008

Launched IIFL Wealth

Transitioned to insurance broking model

2007

Commenced institutional equities business under IIFL

Formed Singapore subsidiary, IIFL (Asia) Pte Ltd

2006

Acquired membership of DGCX

Commenced the lending business


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2005

Maiden IPO and listed on NSE, BSE

2004

Acquired commodities broking license

Launched Portfolio Management Service

2003

Launched proprietary trading platform Trader Terminal for retail

customers

2000

Launched online trading through www.5paisa.com Started

distribution of life insurance and mutual fund

1999

Launched www.indiainfoline.com

1997

Launched research products of leading Indian companies, key

sectors and the economy Client included leading FIIs, banks and

companies.

1995

Commenced operations as an Equity Research firm
http://www.5paisa.com/http://www.indiainfoline.com/http://www.indiainfoline.com/http://www.5paisa.com/


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VISION, MISSION & QUALITY POLICY

VISION

To be the most respected company in the financial service space. To be the leading investment intermediary for transaction through both online and offline

medium.To be thepremier provider of investment advisory and financial planning services in India.

Share holders General public

Growth at above industry rate

with de-risking

High ROCE, ROE

Corporate governance

Transparency

MISSION

One stop shop for all financial requirements.

QUALITY POLICY

Excellence is all about the quality of work. We strive for delivery that is 100% error free andyet at lightning speed. Excellence deals with the quality of work.

Customers Employees

Cutting edge technology

High service standards

Skill development by investments

in training

Empowerment and conducive

work environment


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CHAPTER 4

DATA ANALYSIS AND INTERPRETATION

THE MARKOWITZ MODEL

Harry Markowitz opened new vistas to modern portfolio selection in March 1952. His report

indicated the importance of correlation among the different stocks' returns in the construction

of a stock portfolio. Markowitz also showed that for a given level of expected return in a

group of securities, one security dominates the other. To find out this, the knowledge of the

correlation coefficients between all possible securities combinations is required. After this,

numerous investment firms and portfolio managers developed "Markowitz algorithms" to

minimize portfolio variance i.e. risk. Even today the term Markowitz diversification is used

to refer to the portfolio construction accomplished with the help of security covariance.

(MPT) proposes how rational investors will use diversification to optimize their portfolios,

and how a risky asset should be priced. The basic concepts of the theory are Markowitz

diversification, the efficient frontier, capital asset pricing model, the alpha and beta

coefficients, the Capital Market Line and the Securities Market Line.

MPT models an asset's return as a random variable, and models a portfolio as a weighted

combination of assets; the return of a portfolio is thus the weighted combination of the assets'

returns. Moreover, a portfolio's return is a random variable, and consequently has an expected

value and a variance. Risk, in this model, is the standard deviation of the portfolio's return.

RISK AND REWARD

The model assumes that investors are risk averse. This means that given two assets that offer

the same expected return, investors will prefer the less risky one. Thus, an investor will take

on increased risk only if compensated by higher expected returns. Conversely, an investor

who wants higher returns must accept more risk. The exact trade-off will differ by investor

based on individual risk


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aversion characteristics. The implication is that a rational investor will not invest in a

portfolio if a second portfolio exists with a more favorable risk-return profile - i.e. if for that

level of risk an alternative portfolio exists which has better expected returns

MEAN AND VARIANCE

It is further assumed that investor's risk / reward preference can be described via a quadratic

utility function. The effect of this assumption is that only the expected return and the

volatility (i.e. mean return and standard deviation) matter to the investor. The investor is

indifferent to other characteristics of the distribution of returns, such as its skew. Note thatthe theory uses a historical parameter, volatility, as a proxy for risk, while return is an

expectation on the future.

Under the model:

Portfolio return is the proportion-weighted combination of the constituent assets'

returns.

Portfolio volatility is a function of the correlation of the component assets. The

change in volatility is non-linearas the weighting of the component assets changes.

In general:

Expected return:

Where R is return.

Portfolio variance:
http://en.wikipedia.org/wiki/Utility_functionhttp://en.wikipedia.org/wiki/Volatilityhttp://en.wikipedia.org/wiki/Meanhttp://en.wikipedia.org/wiki/Standard_deviationhttp://en.wikipedia.org/wiki/Skewnesshttp://en.wikipedia.org/wiki/Linear_combinationhttp://en.wikipedia.org/wiki/Correlationhttp://en.wikipedia.org/wiki/Linearhttp://en.wikipedia.org/wiki/Linearhttp://en.wikipedia.org/wiki/Correlationhttp://en.wikipedia.org/wiki/Linear_combinationhttp://en.wikipedia.org/wiki/Skewnesshttp://en.wikipedia.org/wiki/Standard_deviationhttp://en.wikipedia.org/wiki/Meanhttp://en.wikipedia.org/wiki/Volatilityhttp://en.wikipedia.org/wiki/Utility_function


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THE EFFICIENT FRONTIER

EFFICIENT FRONTIER

Every possible asset combination can be plotted in risk-return space, and the collection of all

such possible portfolios defines a region in this space. The line along the upper edge of this

region is known as the efficient frontier(sometimes theMarkowitz frontier). Combinations

along this line represent portfolios for which there is lowest risk for a given level of return.

Conversely, for a given amount of risk, the portfolio lying on the efficient frontier represents

the combination offering the best possible return. Mathematically the Efficient Frontier is the

intersection of the Set of Portfolios with Minimum Variance and the Set of Portfolios with

Maximum Return.

The efficient frontier is illustrated above, with return p on the y axis, and risk p on the x

axis; an alternative illustration from the diagram in the CAPM article is at right.

The efficient frontier will be convex this is because the risk-return characteristics of a

portfolio change in a non-linear fashion as its component weightings are changed. (As

described above, portfolio risk is a function of the correlation of the component assets, and

thus changes in a non-linear fashion as the weighting of component assets changes.)

The region above the frontier is unachievable by holding risky assets alone. No portfolios can

be constructed corresponding to the points in this region. Points below the frontier are

suboptimal. A rational investor will hold a portfolio only on the frontier.
http://en.wikipedia.org/wiki/Capital_asset_pricing_model#The_efficient_.28Markowitz.29_frontierhttp://en.wikipedia.org/wiki/Capital_asset_pricing_model#The_efficient_.28Markowitz.29_frontierhttp://en.wikipedia.org/wiki/Capital_asset_pricing_model#The_efficient_.28Markowitz.29_frontierhttp://en.wikipedia.org/wiki/Correlationhttp://en.wikipedia.org/wiki/Image:Markowitz_frontier.jpghttp://en.wikipedia.org/wiki/Correlationhttp://en.wikipedia.org/wiki/Capital_asset_pricing_model#The_efficient_.28Markowitz.29_frontierhttp://en.wikipedia.org/wiki/Capital_asset_pricing_model#The_efficient_.28Markowitz.29_frontier


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THE RISK-FREE ASSET

The risk-free asset is the (hypothetical) asset, which pays a risk-free rate - it is usually

proxied by an investment in short-dated Government securities. The risk-free asset has zerovariance in returns (hence is risk-free); it is also uncorrelated with any other asset (by

definition: since its variance is zero). As a result, when it is combined with any other asset, or

portfolio of assets, the change in return and also in risk is linear.

Because both risk and return change linearly as the risk-free asset is introduced into a

portfolio, this combination will plot a straight line in risk-return space. The line starts at

100% in cash and weight of the risky portfolio = 0 (i.e. intercepting the return axis at the risk-

free rate) and goes through the portfolio in question where cash holding = 0 and portfolio

weight = 1.

Using the formulae for a two asset portfolio as above:

Return is the weighted average of the risk free asset, f, and the risky portfolio,

p, and is therefore linear:

Return =

Since the asset is risk free, portfolio standard deviation is simply a function of

the weight of the risky portfolio in the position. This relationship is linear.

Standard deviation =

=

=

=
http://en.wikipedia.org/wiki/Risk-free_ratehttp://en.wikipedia.org/wiki/Risk-free_rate


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PORTFOLIO LEVERAGE

An investor can add leverage to the portfolio by borrowing the risk-free asset. The addition of

the risk-free asset allows for a position in the region above the efficient frontier. Thus, bycombining a risk-free asset with risky assets, it is possible to construct portfolios whose risk-

return profiles are superior to those on the efficient frontier

An investor holding a portfolio of risky assets, with a holding in cash, has a positive

risk-free weighting (a de-leveraged portfolio). The return and standard deviation will

be lower than the portfolio alone, but since the efficient frontier is convex, this

combination will sit above the efficient frontieri.e. offering a higher return for the

same risk as the point below it on the frontier.

The investor who borrows money to fund his/her purchase of the risky assets has a

negative risk-free weighting -i.e. a leveraged portfolio. Here the return is geared to the

risky portfolio. This combination will again

offer a return superior to those on the frontier.

THE MARKET PORTFOLIO

The efficient frontier is a collection of portfolios, each one optimal for a given amount of

risk. A quantity known as the Sharpe ratio represents a measure of the amount of additional

return (above the risk-free rate) a portfolio provides compared to the risk it carries. The

portfolio on the efficient frontier with the highest Sharpe Ratio is known as the market

portfolio, or sometimes the super-efficient portfolio; it is the tangency-portfolio in the abovediagram.

This portfolio has the property that any combination of it and the risk-free asset will produce

a return that is above the efficient frontier - offering a larger return for a given amount of risk

than a portfolio of risky assets on the frontier would.
http://en.wikipedia.org/wiki/Market_portfoliohttp://en.wikipedia.org/wiki/Market_portfoliohttp://en.wikipedia.org/wiki/Market_portfoliohttp://en.wikipedia.org/wiki/Market_portfolio


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CAPITAL MARKET LINE

When the market portfolio is combined with the risk-free asset, the result is the Capital

Market Line. All points along the CML have superior risk-return profiles to any portfolio onthe efficient frontier. (The market portfolio with zero cash weighting is on the efficient

frontier; additions of cash or leverage with the risk-free asset in combination with the market

portfolio are on the Capital Market Line. All of these portfolios represent the highest Sharpe

ratios possible.)

The CML is illustrated above, with return p on the y axis, and riskp on the x axis. One can

prove that the CML is the optimal CAL and that its equation is:

Capital market line
http://en.wikipedia.org/wiki/Image:Capital_Market_Line.pnghttp://en.wikipedia.org/wiki/Image:Capital_Market_Line.png


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ASSET PRICING

A rational investor would not invest in an asset which does not improve the risk-return

characteristics of his existing portfolio. Since a rational investor would hold the marketportfolio, the asset in question will be added to the market portfolio. MPT derives the

required return for a correctly priced asset in this context.

SYSTEMATIC RISK AND SPECIFIC RISK

Specific risk is the risk associated with individual assets - within a portfolio these risks can be

reduced through diversification (specific risks "cancel out"). Systematic risk, or market risk,

refers to the risk common to all securities - except for selling short as noted below, systematicrisk cannot be diversified away (within one market). Within the market portfolio, asset

specific risk will be diversified away to the extent possible. Systematic risk is therefore

equated with the risk (standard deviation) of the market portfolio.

Since a security will be purchased only if it improves the risk / return characteristics of the

market portfolio, the risk of a security will be the risk it adds to the market portfolio. In this

context, the volatility of the asset, and its correlation with the market portfolio, is historically

observed and is therefore a given (there are several approaches to asset pricing that attempt to

price assets by modelling the stochastic properties of the moments of assets' returns - these

are broadly referred to as conditional asset pricing models). The (maximum) price paid for

any particular asset (and hence the return it will generate) should also be determined based on

its relationship with the market portfolio.

Systematic risks within one market can be managed through a strategy of using both long and

short positions within one portfolio, creating a "market neutral" portfolio.
http://en.wikipedia.org/wiki/Systematic_riskhttp://en.wikipedia.org/wiki/Systematic_risk


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SECURITY CHARACTERISTIC LINE

The Security Characteristic Line (SCL) represents the relationship between the market

return (rM) and the return of a given asset i (ri) at a given time t. In general, it is reasonable toassume that the SCL is a straight line and can be illustrated as a statistical equation:

Where i is called the asset's alpha coefficient and i the asset's beta coefficient.
http://en.wikipedia.org/wiki/Straight_linehttp://en.wikipedia.org/wiki/Alpha_coefficienthttp://en.wikipedia.org/wiki/Beta_coefficienthttp://en.wikipedia.org/wiki/Beta_coefficienthttp://en.wikipedia.org/wiki/Alpha_coefficienthttp://en.wikipedia.org/wiki/Straight_line


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CAPITAL ASSET PRICING MODEL

The Capital Asset Pricing Model (CAPM) is used in finance to determine a theoretically

appropriate required rate of return (and thus the price if expected cash flows can beestimated) of an asset, if that asset is to be added to an already well-diversified portfolio,

given that asset's non-diversifiable risk. The CAPM formula takes into account the asset's

sensitivity to non-diversifiable risk (also known as systematic risk or market risk), in a

number often referred to as beta () 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,William Sharpe,John Lintnerand Jan Mossin

independently, building on the earlier work of Harry Markowitz on diversification and

modern portfolio theory. Sharpe received the Nobel Memorial Prize in Economics (jointly

with Harry Markowitz and Merton Miller) for this contribution to the field of financial

economics.
http://en.wikipedia.org/wiki/Financehttp://en.wikipedia.org/wiki/Assethttp://en.wikipedia.org/wiki/Riskhttp://en.wikipedia.org/wiki/Systematic_riskhttp://en.wikipedia.org/wiki/Market_riskhttp://en.wikipedia.org/wiki/Beta_coefficienthttp://en.wikipedia.org/wiki/Risk-free_interest_ratehttp://en.wikipedia.org/w/index.php?title=Jack_L._Treynor&action=edithttp://en.wikipedia.org/wiki/William_Forsyth_Sharpehttp://en.wikipedia.org/wiki/John_Lintnerhttp://en.wikipedia.org/wiki/Jan_Mossinhttp://en.wikipedia.org/wiki/Diversificationhttp://en.wikipedia.org/wiki/Modern_portfolio_theoryhttp://en.wikipedia.org/wiki/Bank_of_Sweden_Prize_in_Economic_Sciences_in_Memory_of_Alfred_Nobelhttp://en.wikipedia.org/wiki/Harry_Markowitzhttp://en.wikipedia.org/wiki/Merton_Millerhttp://en.wikipedia.org/wiki/Financial_economicshttp://en.wikipedia.org/wiki/Financial_economicshttp://en.wikipedia.org/wiki/Financial_economicshttp://en.wikipedia.org/wiki/Financial_economicshttp://en.wikipedia.org/wiki/Merton_Millerhttp://en.wikipedia.org/wiki/Harry_Markowitzhttp://en.wikipedia.org/wiki/Bank_of_Sweden_Prize_in_Economic_Sciences_in_Memory_of_Alfred_Nobelhttp://en.wikipedia.org/wiki/Modern_portfolio_theoryhttp://en.wikipedia.org/wiki/Diversificationhttp://en.wikipedia.org/wiki/Jan_Mossinhttp://en.wikipedia.org/wiki/John_Lintnerhttp://en.wikipedia.org/wiki/William_Forsyth_Sharpehttp://en.wikipedia.org/w/index.php?title=Jack_L._Treynor&action=edithttp://en.wikipedia.org/wiki/Risk-free_interest_ratehttp://en.wikipedia.org/wiki/Beta_coefficienthttp://en.wikipedia.org/wiki/Market_riskhttp://en.wikipedia.org/wiki/Systematic_riskhttp://en.wikipedia.org/wiki/Riskhttp://en.wikipedia.org/wiki/Assethttp://en.wikipedia.org/wiki/Finance


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SECURITIES MARKET LINE

The relationship between Beta & required return is plotted on the securities market

line (SML) which shows expected return as a function of . The intercept is the risk-

free rate available for the market, while the slope is . 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:

SECURITY MARKET LINE
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THE FORMULA

The CAPM is a model for pricing an individual security (asset) or a portfolio. For individual

security perspective, we made use of the security market line (SML) and its relation toexpected 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 the overall markets. 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:

Individual securitys = Markets securities (portfolio)

Reward-to-risk ratio Reward-to-risk ratio

,

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

(the beta coefficient) the sensitivity of the asset returns to market returns, or also

,

is the expected return of the market
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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).

Note 1: the expected market rate of return is usually measured by looking at the

arithmetic average of the historical returns on a market portfolio (i.e. 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.

ASSET PRICING

Once the expected return, E(Ri), is calculated using CAPM, the future cash flows of the asset

can be discounted to theirpresent value using this rate (E(Ri)), to establish the correct price

for the asset.

In theory, therefore, an asset is correctly priced when its observed price is the same as its

value calculated using the CAPM derived discount rate. If the observed price is higher than

the valuation, then the asset is overvalued (and undervalued when the observed price is below

the CAPM valuation).

Alternatively, one can "solve for the discount rate" for the observed price given a particular

valuation model and compare that discount rate with the CAPM rate. If the discount rate in

the model is lower than the CAPM rate then the asset is overvalued (and undervalued for a

too high discount rate).
http://en.wikipedia.org/wiki/Arithmetichttp://en.wikipedia.org/wiki/Cash_flowhttp://en.wikipedia.org/wiki/Discountedhttp://en.wikipedia.org/wiki/Present_valuehttp://en.wikipedia.org/wiki/Present_valuehttp://en.wikipedia.org/wiki/Discountedhttp://en.wikipedia.org/wiki/Cash_flowhttp://en.wikipedia.org/wiki/Arithmetic


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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 relativeriskiness. 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. 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.

RISK AND DIVERSIFICATION

The risk of a portfolio comprises systemic risk and specific risk which is also known as

idiosyncratic risk. Systemic risk refers to the risk common to all securities - i.e. market risk.

Specific risk is the risk associated with individual assets. Specific risk can be diversified

away to smaller levels by including a greater number of assets in the portfolio. (Specific risks

"average out"); systematic risk (within one market) cannot. Depending on the market, a

portfolio of approximately 30-40 securities in developed markets such as UK or US (more in

case of developing markets because of higher asset volatilities) will render the portfolio

sufficiently diversified to limit exposure to systemic risk only.

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

systemic exposure taken by an investor.
http://en.wikipedia.org/wiki/Riskhttp://en.wikipedia.org/wiki/Mutual_fundhttp://en.wikipedia.org/wiki/Portfolio_(finance)http://en.wikipedia.org/wiki/Systemic_riskhttp://en.wikipedia.org/wiki/Specific_riskhttp://en.wikipedia.org/w/index.php?title=Idiosyncratic_risk&action=edithttp://en.wikipedia.org/wiki/Market_riskhttp://en.wikipedia.org/wiki/Diversificationhttp://en.wikipedia.org/wiki/Return_on_investmenthttp://en.wikipedia.org/wiki/Variancehttp://en.wikipedia.org/wiki/Variancehttp://en.wikipedia.org/wiki/Return_on_investmenthttp://en.wikipedia.org/wiki/Diversificationhttp://en.wikipedia.org/wiki/Market_riskhttp://en.wikipedia.org/w/index.php?title=Idiosyncratic_risk&action=edithttp://en.wikipedia.org/wiki/Specific_riskhttp://en.wikipedia.org/wiki/Systemic_riskhttp://en.wikipedia.org/wiki/Portfolio_(finance)http://en.wikipedia.org/wiki/Mutual_fundhttp://en.wikipedia.org/wiki/Risk


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THE EFFICIENT FRONTIER

EFFICIENT FRONTIER

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 portfo

project on portfolio cunstrection

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