PORTFOLIO MANAGEMENT

Portfolio:
Portfolio is the combination of more than one security. That is combination shares,
debentures, etc..

Portfolio Construction Approaches:

There are two approaches;
1. Traditional Approach.
2. Modern Approach. (Markowitz efficient frontier Model)

Traditional Approach
• Individual specific planning
• Individual in nature.
• Individual consideration.

Steps for Portfolio construction is Traditional approach:

1. Analyzing the constraints
2. Determination of objectives.
3. Selection of portfolio.
4. Risk return analysis
5. Diversification.

Modern Approach:
Portfolio theory, originally proposed by Harry Markowitz in the 1950s, was the first formal
attempt to quantify the risk of a portfolio and develop a methodology for determining the optimal
portfolio. Prior to the development of portfolio theory, investors dealt with the concepts of return
& risk somewhat loosely. Intuitively smart investors knew the benefit of diversification which is
reflected in the traditional approach “Do not put all your eggs in one basket.” Harry Markowitz
was the first person to show quantitatively why and how diversification reduces risk.

TYPES OF RISK
SYSTEMATIC RISK & UNSYSTEMATIC RISK
Risk consists of two components, the systematic risk and unsystematic risk. The
systematic risk is caused by factors external to the particular company and uncontrollable by the
company. The systematic risk affects the markets as a whole. In case of unsystematic risk the
factors are specific unique and related to the particular industry or company.

Systematic Risk: The systematic risk affects the entire market. Often we read in the news papers
that the stock market is in the bear bug or in the bull grip. This indicates that the entire market is
moving in a particular direction either downward or upward. The economic conditions, political
situations and the sociological changes affect the security market. These factors are beyond the
control of the corporate and the investor. They cannot be entirely avoided by the investor. It
drives home the point that the systematic risk is unavoidable.
The systematic risk is further sub-divided into:
1. Market Risk
2. Interest Rate Risk
3. Purchasing Power Risk.

MARKET RISK: Jack Clark Francis defined market risk as that portion of total variability of
return caused by the alternating forces of bull and bear markets. When the security index moves
upward haltingly for a significant period of time, it is known as bull market. In the bull market,
the index moves form low level to the peak. Bear market is just reverse to a market low point for
a significant period to time.
The forces that affect the stock market are tangible and intangible events. The tangible
events are real events such as earthquake, political uncertainty, fall in the value of currently etc.
Intangible events are related to market psychology.

Interest Rate Risk: Interest rate risk is the variation in the single period rates of return caused
by the fluctuations in the interest rate. Most commonly interest rate risk affects the price of
bonds, debentures and stocks. The fluctuations in the interest rates are caused by the changes in
the government monetary policy and the changes that occur in the interest rates of treasury bills
and the governments bonds. The bonds issued by government and quasi government are
considered to be risk free. If higher interest rates are offered, investor would like to switch his
investment form private sector bonds to public sector bonds.
Like wise, if stock market is in a depressed condition, investors would like to shift their
money to the bond market, to have an assured rate of return.
The rise of fall in the interest rates affects the cost of borrowings. Most of the stock
traders trade in the stock market with the borrowed funds. The increase in the cost of margin
affects the profitability of the traders.
Interest rates also affect the corporate bodies that carry their business with borrowed
funds.

Purchasing Power Risk: Variations in the returns are caused also by the lose of purchasing
power of currency. Inflation is the reason behind the loss of purchasing power. The level of
inflation proceeds faster than the increase in capital value. Purchasing power risk is the probable
loss in the purchasing power of the returns to be received. The rise in the price penalizes the
returns to the investor and every potential rise in price is a risk to the investor.

UNSYSTEMATIC RISK: As already discussed, unsystematic risk is unique and peculiar to a

firm or an industry. Unsystematic risk stems form managerial inefficiency, technological change
in the production process, change in the customer preferences, labour problems etc.
Unsystematic risk can be classified into;
1. Business Risk
2. Financial Risk.

Business Risk: it is that portion of the unsystematic risk caused by the operating environment of
the business. Business risk arise form the inability of a firm to maintain its competitive edge and
the growth or stability of the earnings. Variation that occurs in the operating income expected
operating income indicates the business risk.
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 differ form company to company.
• Fluctuations in the sales
• Research & Development
• Personnel Management
• Fixed cost
• Single Product.

External Risk: External risk is the result of operating conditions imposed on the firm by
circumstance beyond its control. The external factors are social, monetary & fiscal policies of the
government, business cycles general economic environment etc.
These factors are mainly divided into:
1. Social & Regulatory factors
2. Political Risk
3. Business Cycle.

Financial Risk: It refers to the variability of the income to the equity capital due to the debt
capital. Financial risk in the company is associated with the capital structure of the company.

THE CHARACTERISTIC REGRESSION LINE (CRL)

The characteristic regression line is a simple linear regression model estimated for a
particular stock against the market index return to measure its diversifiable and undiversifiable
risks. The model is,

Ri = α i + β i Rm + e i

Ri = Return of the ith stock.

αi = Intercept
βi = Slope of ith stock
Rm = Return of the market index
ei = The error term.

The security return is –

Today’s price - Yesterday’s price
Today’s Security return = -------------------------------------------- × 100
Yesterday’s price

Today’s Index – Yesterday’s Index

Today’s Market return = ---------------------------------------------× 100
Yesterday’s index
To calculate beta, the returns have to be calculated then using the formula the beta and alpha co-
efficient can be calculated.

nΣ XY – (ΣX) (ΣY)
β= ---------------------------
nΣ X2 – (Σ X) 2
_ _
α = Y – βX

Calculation of Residual variance:

ΣY2 - α ΣY - β ΣX
2
e = ---------------------------
n

e2= e2
Beta: Beta is the slope of the characteristic regression line. Beta describes the relationship
between the stock’s return and the index return.

Beta = +1.0: One % change in market index return causes exactly one % change in stock return.

Beta = +0.5: One % change in market index return causes 0.5 % change in stock return. The
stock is less volatile compared to the market.

Beta = +2.0: One % change in market index return causes 2 % change in stock return. The stock
return is more volatile.

Negative Beta Value: It indicates that the stock return moves in the opposite direction to the
market return.

S S S
t t t
o o o
c c β>1 c β <1
k β=1 k k

r r r
e e e
t t t
u u u α
r r r
n α n α n

Market Return Market Return Market Return

A B C
 A- Systematic Risk as Market.
B- High Systematic Risk.
C- Low Systematic Risk.

Alpha: The intercept of the characteristic regression line is alpha. It is the difference between the
horizontal axis and line’s intersection with y-axis. It measures unsystematic risk of the company.
It indicates that stock return is independent of the market return. A positive alpha is a healthy
sign.

Beta: Beta measures the systematic risk which cannot be eliminated.

THE EXPECTED RETURN ON PORTFOLIO OF RISKKY ASSETS

The portfolio analysis we often want to know the expected (or anticipated) return on a
portfolio of risky assets.
The expected return on a portfolio is:
E(Rp) = Wi E(R1) + W2 E(R2) + ...................+ Wn E(Rn)

Where E(Rp) = Expected return on a portfolio.

Wi = Weight of asset i in the portfolio
E(Ri) = Expected return on asset;

E(Rp) = ΣWi E(R1)

PORTFOLIO RISK: Holding two securities may reduce the portfolio risk too. The portfolio
risk can be calculated with the help of following formula;

σp = Wi2σi2 + W22σ22 + 2W1W2 (r12σ1σ2)

σp = Portfolio standard deviation W1 = Weight of the asset (1) in portfolio

W2 = Weight of the asset (2) in portfolio σ1 = SD of Stock1
σ2 = SD of Stock2 r12 = Correlation in co-efficient of W1 & W2

σA2 = ∑Pi [ RA,I – E(RA) ]2

σB2 = ∑Pi [ RB,I – E(RB) ]2
σA,B = ∑Pi [ RA,I – E(RA) ] [ RB,I – E(RB) ]

σA,B σA,B
rA,B = ------------ βA,B = -----------
σA×σB σB2
σA2, σB2 = Variance of returns on investments A & B.
Pi = Probability of the state of nature;
RA, RB = Holding period return on investments A & B if the state of nature i occurs.
E(RA), E(RB) = Expected return on investments A & B.
σA,B = Co – variance of the returns on investments A & B.
rA,B = Co – efficient of correlation of the returns on investments A & B
σA, σB = Standard deviations of returns.
βA,B = Beta of return on A with respect to B.
CAPM & APT
Capital Asset Pricing Model
Harry Markowitz developed an approach that helps an investor to achieve his optimal
portfolio position. Hence, portfolio theory, in essence, has a normative character as it prescribes
what a rational investor should do.
William Sharpe and others asked the follow-up question: If rational investors follow the
Markowitzian prescription, what kind of relationship exists between risk and return? Essentially,
the capital asset pricing model (CAPM) developed by them is an exercise in positive economics.
It is concerned with two key questions:
• What is the relationship between risk and return for an efficient portfolio?
• What is the relationship between risk and return for an individual security?
The CAPM, is essence, predicts the relationship between the risk of an asset and its expected
return. This relationship is very useful in two important ways. First, it produces a benchmark for
evaluating various investments. Second, it helps us to make an informed guess about the return
that can be expected from an asset that has not yet been traded in the market.
Although the empirical evidence on the CAPM is mixed, it is widely used because of the
valuable insight it offers and its accuracy is deemed satisfactory for most practical applications.

CAPM is discussed as fallows:-

1. Basic assumptions
2. Capital Market Line (CML)
3. Security Market Line (SML)
4. Inputs required for CAPM
5. Empirical evidence on CAPM.

BASIC ASSUMPTIONS

The CAPM is based on the following assumptions:

1. Individuals are risk averse.
2. Individuals seek to maximize the expected utility of their portfolio over a single period
planning horizon.
3. Individuals have homogeneous expectations – they have identical subjective estimates of
the means, variances and covariance among returns
4. Individuals can borrow and lend freely at a riskless rate of interest.
5. The market is perfect; there are no taxes; there are no transaction costs; securities are
completely divisible; market is competitive.
6. The quantity of risky securities in the market is given.
Risk is measured by variance of expected returns there are two components of risk systematic
(non – diversifiable) and unsystematic (diversifiable). For diversifiable risk, the investor makes
proper diversification to reduce the risk. For the non – diversifiable portion, he uses the relevant
Beta measure to adjst to his requirements. Due to the possibility of risk free asset and lending
and borrowing at risk free interest rates, the investors have two components of the portfolio –
risk free assets and risky assets.
The expected return on the combination of risky and risk free combination is;
Rp = RfXf + Rm (1 – Xf )
Rp = Return on portfolio
Xf = Proportion of funds invested in the risk free assets.
Rf = Risk free rate of return
Rm= Return on risky assets.
1-Xf = Proportion of funds invested in the risky assets.

CAPITAL MARKET LINE (CML)

y Z CML
E Rp CML
x Rm M B C
p
e Rm – Rf
c (Measure of Risk premium
t
e
d
Rf A
R
e
t (Risk less return)
u
r
n
Fig – 1 Fig – 2
Risk (σ)
Figure – 1

Point ‘Rf’ is the risk less interest rate. Preferred investments are plotted along the line R f MZ, by
the combination of both risky assets and risk free assets, along with borrowing and lending. This
is known as CML. It gives desirable set of investment opportunities between risk free and risky
investments. The slope of Rf MZ is the measure of the reward for risk taking. P is the risk free
return. Rm – Rf is the measure of the risk premium – a return for the risk taking.

Figure – 2

The line Rf B represents all possible combination of risk less and risky assets. The portfolio
along with the path Rf B is called lending portfolio. If it crosses B it becomes borrowing
portfolio. (Combination of risky portfolio with borrowing). Borrowing increases both the
expected return and the risk while lending (i,e combining risky portfolio with risk free asset)
reduces the expected return & risk.
Thus the investors with high risk aversion will prefer to lend and thus hold a combination of
risky asset and risk free asset. Others with less risk aversion will borrow and invest more in the
risky portfolio, ABC represent efficient frontier. ABC line show the investor’s portfolio of risky
assets. The investors can combine risk less asset either by lending or borrowing.
ABC is concave curve represent an efficient frontier of risky portfolios.
Introduction of borrowing and lending gives us an efficient frontier that is straight line
through out.
E (Rm – Rf)

Risk (σ)
 E(Rp) = Rf +-------------------× σp
σm
E(Rp) = Portfolio’s expected return.
Rm = Expected return on the market portfolio.
σm = Standard deviation of market portfolio.
σp = Standard deviation of the portfolio.

SECURITY MARKET LINE

The risk-return relationship of an efficient portfolio is measured by the capital market
line. All portfolios other than efficient portfolios will lie below the CML. The CML does not
describe the risk – return relationship of inefficient portfolios of individual securities. The
CAPM specifies the relationship between expected return and risk for all securities and all
portfolios, whether efficient of inefficient.
We have seen earlier that the total risk of a security as measured by standard deviation is
composed of two components; systematic risk & unsystematic risk of diversifiable risk. As
Investment is diversified and more and more securities are added to a portfolio, unsystematic risk
tends to become zero and the only relevant risk is systematic risk measured by Beta (β). Hence it
is argued that, the correct measure of security risk is beta. The beta analysis is useful for
individual securities and portfolios whether efficient of inefficient.
The relationship between expected return and β of a security can be determined
graphically. Lit us consider an XY graph where the expected returns are plotted on the OY axis
and beta coefficient on OX axis. A risk free asset has expected return equivalent to Rf and beta co
– efficient is zero (0). The Market Portfolio M has a beta co – efficient of I and expected return
equivalent to Rm. A straight line joining these tow point is known as the Security Market Line
(SML). The SML helps to determine the expected return for a given security beta. This is
explained in the following figure.

Rp Security Market Line

SML
M
Rm

Rf

I Beta

The Security Market Line provides the relationship between the expected return and beta of a
security or portfolio. This relationship can be expressed in the form of the following equation.
E(Rj) = Rf + βi [ E(Rm) – Rf ]
Inputs required for applying CAPM
• Risk free rate
• Market risk premium
• Beta.

CAPM & Capital Budgeting:

We can apply the CAPM to figure out a projects required rate of return.

Equity Beta and Asset Beta:

βE
D
βE = βA [ 1 + / E ( 1 – T ) ] βA = ------------------------
[ 1 + D/E(1 – T )

Procedure for calculation a project’s required rate of return; (as per CAPM)

• Find a sample of firms engaged in the same line of business.

• Obtain equity betas for the sample firms
• Derive assets betas
• Find the average of the asset betas
• Figure out the equity beta for the proposed project.
• Estimate cost equity re = Rf (Rm – Rf) β
• Calculate the project’s required rate of return

rA = WE rE + WDrD (1 – T)

rA = Weighted average cost of capital.

Pricing of securities with CAPM:

Evaluation of securities:

T
E S x
s R x C
t
i x B x
m A x
a
t x x
e x W
d
x V
r U
e
t Rf
u
r
n

0.7 1.0 1.3

Beta