UTILITY THEORY:

Utility theory is the theory of choice under uncertainty. Utility is the power of a commodity to
satisfy human need. According to portfolio utility is number of choices to investment &
according to economy utility is warm satisfied at a specific point.

TYPES OF UTILITY:
Utility consist of two major types.

1. Cardinal utility
2. Ordinal utility

Cardinal utility
Cardinal utility is a measurable utility. Commodity assigned in a number, amount or degree of
utility.

Ordinal utility
Ordinal utility is un-measurable these utility satisfy need to customer but not able to measure
commodities in number, amount & degree form.

MEASURING UTILITY:
Calculating the benefit that consumers receive from its difficult to pinpoint. Basically utility
measured by wealth.

EQUATION:
μ=fμw , σw

( μw ; expected future wealth & σw ; actual future wealth ¿

Simple utility measured by

μ=Wi× Pi

(Wi ; wealth o utcomes∧Pi; individual probability outcomes)

MARKOWITZ MODEL:
In 1952 Henry Markowitz derived Markowitz Model. This model lies in three things.

1. Diversification.
2. Correlation ship; negative correlation between assets & stocks.
3. Risk & Return. Its means maximize the return for any level of risk.

PURPOSE OF MARKOWITZ MODEL:

The main purpose of this model is benefit & diversifies the risk reduction effect on portfolio.

ASSUMPTION OF MARKOWITZ MODEL:

Assumptions based on concerning the behavior of investor. This model consist of following
assumptions are;

1. Return is desirable; risk is too avoided.

2. Investor will use only expected return & risk to make investment decision.
3. Variability about the possible values of return is used by investor or measure risk.
4. Investors have single period utility function in which in frame work of diminishing
marginal utility of wealth.
5. Expected return & risk used by investors are measured by first two moments of the
probability distribution of return; expected value & variance.
6. Distribution of profitability of possible returns over some holding period can be
estimated by investors.

TYPES OF UTILITY CURVES:

Utility curves classified in to three curves can be classified are as under;

 Linear curve.
 Concave curve.
 Convex curve.

Linear curve:
Linear curve show that constant relationship between utility & wealth. This relationship is a
direct relation it means that if utility will be increase so wealth will also be increase. These
relationships also clear in below graph.
 Linear curve

Utility

0
Wealth

This curve show direct relationship.

Concave curve.
Concave curve show that relationship between utility & wealth. This relationship is an inverse
relation it means that if wealth will be increase so utility will be decrease. These relationships
also clear in below graph.

Concave curve

Utility

0
Wealth
This curve show inverse relationship
CONVEX CURVE:
Convex curve show that relationship between utility & wealth. This relationship is an inverse
relation it means that if utility will be high but wealth will be low. These relationships also clear
in below graph.

Convex curve

Utility

0
Wealth

This curve show inverse relationship.

Example:
Examples of linear curve consider how the shape of an individual utility function effects his or
her reaction to risk. Assume that an individual who has $ 10,000 & whose behavior is a linear
utility function is offered to chance to gain $20,000 with probability ½ or to lose $ 20,000 with
probability of 1/2. Answer is nothing because one amount is positive & one is negative so it will
be constant in linear function that is;

E (V) =1/2 10,000 +1/2 – 10,000 = 0.

UTILITY FUNCTIONS:
Utility functions are;

UP WORD SLOPING FUNCTION:

Up word sloping show that relationship between wealth & utility it’s a direct relationship if in
case of wealth will be increase so satisfaction will also be increases.

INDIFFERENCE CURVE OF UTILITY FUNCTION:

Indifference curve expected utility is isoquant its means that various combination of risk &
return to provide equal amount of expected utility. In other words indifference cure is that
investor expected to prefer higher expected future wealth to a lower value it called risk averse.

OPTIMAL PORTFOLIO:
Optimal portfolio along the efficient frontier is not unique with this model & depends upon the
risk / return tradeoff utility function of each investor. Optimal portfolio would be the one that
provides the highest utility. In optimal portfolio risk will be low but return will be high. Optimal
portfolio chooses risk averse investor.

INDIFFERENCE CURVE:
Slope of indifference curve is a function of the investors for a lower return & higher risk.

Indifference curve consist of four parts.

1. RISK AVERSE INVESTOR

In risk averse investor return & risk both are decrease.
 E(R)
U1 U2

σ
Risk-averse investor

2. RISK NEUTRAL INCVESTOR:

In risk neutral investor return & risk both will be change according to situation.

E(R)
U1
U2

Risk- neutral investor σ

3. RISK SEEKER INVESTOR:
In risk seeker investor return & risk both will be increase.

E(R)

U1

U2

Risk- neutral investor σ

4. LEVEL OF RISK AVERSION:

In level of risk aversion first curve show that risk & return will same but they move on so both
will be change. Than second curve show that return will be decrease but risk will be same &
the last third curve show that risk will be same but return will be change.

E(R)

Investor 1 Investor2

E(R1)

E(R2)
E(R0)

σ0 σ1 σ
 EFFICIENT FRONTIER:
Allows investors to understand & how a portfolio expected returns vary with the amount of
risk taken.

Efficient frontier

Maximum variance portfolio

SHORT SELLING:
A short selling is a selling share of a stock that is borrowed in expectation of a fall in the security
price. Short selling is a type of market transaction. When & if the price decline; the investor
buys an equitant number of shares of the same stock at the new lower price & return to the
lender stock that was borrowed.

EXAMPLE:

If investors think that tesla stock is over valued at $315 per share & is going to drop in price the
investor may borrow 10 shares of tesla from their broker & sell it for the current price of $ 315.

RISK AVERSION:
Risk aversion describes the low risk investment if unspectacular return value will be less than
zero. It means that it is risk aversion. In risk aversion investors who prefer lower return within
the given level of risk rather than higher return. Avoid risk; & no invest on highly risk assets like
government bond.
MARKET PORTFOLIO:
Market portfolio is the bundles of investment that includes different assets available in the
finance market. It contains different number of assets & it contains all securities & the
proportion of each security is its market value as a % of total market. All investors will hold the
same portfolio for risky assets (market portfolio).

CAPITAL MARKET LINE:

CML is the representation of graph of the required return & risk as a measured by standard
deviation of an portfolio of a risk free asset & a basket of risky assets that offers the best risk
return trend effect.

EQUATION:

CML; ERp = Rf + SDp × ERm – Rf / SDm

GRAPHICAL REPRESENTATION OF CML:

CML representation shows through graph are;

CML

Efficient frontier

Expected return M

Standard deviation
CML move up will increase the risk of portfolio & moving down than decrease the risk of
portfolio.

SECURITY MARKET LINE:

The SML line is a geographical representation of the expected return & β relationship also SML
line we can say represent the CAPM model.

EQUATION:

SML; E(R) = Rf + β(E (Rm) – Rf)

GRAPHICAL REPRESENTATION OF SML:

E(R)

(SML)

E (Rm) M

E (R); Expected return on security.

(β); Systematic risk.

E (Rm); Expected return on market portfolio.

DIFFERENCE:
Sharpe ratio evaluate the performance of a portfolio based on the total risk of a portfolio but
Treynor ratio evaluate the performance of a portfolio based on the systematic risk of a fund &
the Jensen ratio used to measure the performance of a active fund manager. It’s a little
difference on all three ratios.

ADVANTAGES & DISADVANTAGES:

Major advantage is that takes the opportunity to excess returns into account when alternative
ranking. Its advantage is Treynor index over the Jensen index. In Sharpe ratio overstates if the
historical price used; it is overstated if the return are smoothen; manipulated by fund managers
if non linear derivatives are used. But in Treynor ratio it is controllable for market risk exposure;
it can be overstate if market nature strategies are used; it is not a proper measure for
undiversified portfolios. & in Jensen ratio it rewards the stock selection ability of fund manager;
it does not consider the advantages by a diversified portfolio; it also doesn’t consider the
positive rewards in the portfolio.

Investor prefer the value from all of these three index that’s all three ratios measures Sharpe
ratio ; Treynor ratio & Jensen ratio seek to measure risk adjusted returns. Many investors focus
on highest absolute returns.

TREYNOR; SHARP & JENSEN PERFORMANCE MEASURES:

TREYNOR INDEX:
Treynor index is the slope of straight line going through the risk free rate of return. In Treynor
index risk premium earn per unit of risk, where beta is the risk measure.

Treynor performance will be measure by expected return minus risk free rate than divided by
beta basically its measure on security line.

Tj = E (rj) – rf / βj

SHARP INDEX:
Sharpe index is the slope of straight line going through the risk free rate of return. In Sharpe
index risk premium earn per unit of risk, where standard deviation of return is the risk
measure.
Sharpe performance will be measure through expected return minus risk free rate than divided
by standard deviation.

Sp = E (rp) – rf / σ ( rp )

JENSEN INDEX:
Jensen index is the vertical distance from the SML.

Jensen performance will be measure through expected return minus expected return on the
SML. It’s also called Jensen Alpha & performance measure ATP.

Jj = E ( rj) – ( rf + { E(rm) – rf } βj )

IMPLICATION OF SML IF THE MARKET PORTFOLIO IS INEFFICIENT:

When the market is inefficient SML is upward sloping due to risk sharping. When there is high
disagreement regarding the future cash-flow & there is costly short selling high beta stocks
which are more sensitive to this inefficient market affected more heavily by this costly short
selling & therefore generate a lower expected return. A portfolios position relative to the SML is
sensitive to the inefficient proxy chosen to represent the true market portfolio.

E(r)

E (rm)

E (rz)

β
MARKET INEFFICIENT:

If the market is inefficient is one perspective in which assets prices do not accurately reflect its
value. Market is inefficient its means that not a perfect competition any one can easily given
the opinion about stock market easily because any one easily estimate the next stock price in
the market. The best of investor to act is that investor easily invest money according to the
market condition if market stock price increase so investor act that its purchase more share but
in case of market stock price will be decrease so investor act that they sellout the stock . All
these two condition is best way for investor to act.

CAPM MODEL:
Markowitz & Jan Mossin developed by CAPM model in 1970 . CAPM model is the relationship
between risk & return of investing security. It consists of following three main components are;

1. Return
2. Risk
3. Market risk premium

ASSUMPTIONS:
CAPM is a theoretical model which requires certain assumptions are;

1. Individual’s investors are price taker.

2. Investments are limited to traded financial assets.
3. No taxes & transactional costs are involved.
4. Information is costless & available to all investors.
5. Investors are rational mean variance optimizers.
6. Homogenous accepectations.

RESULTING EQUILIBRIUM CONDITIONS:

1. All investors will hold the same portfolio for risky assets.
2. Market portfolio contains all securities & the proportion of each security is its market
value as a% of total market value.
3. Risk premium on the market depends up on the average risk aversion of all market
participants.
4. Risk premium on an individual security is a function of its covariance with the market.
LIMITATION OF CAPM MODEL:
1. The CAPM is based on expected conditions but we only have historical data to use to
estimate beta.
2. Time frame (frequency of returns & historical time period used for the regression of the
historical data) greatly impact our estimates of beta.
3. As conditions change future volatility may differ for past volatility. Volatility here just
means magnitude in the changes of prices.
4. Where does the forecast for the risk free rate & the required rate of return for the
market comes back.
5. Alternatives multifactor models have been developed to try to address some of these
limitations. Multifactor means that there are more explanatory variables on the right
hand side of the regression.

APT & CAPM COMPARISION:

1. APT applies to well diversified portfolio & not necessarily to individual stocks.
2. With APT it is possible for some individual stock to be misprice that is they may not lie on
the SML.
3. APT is more general in that is gets to an expected return & beta relationship without the
assumptions of CAPM theory.
4. APT can the extended to multifactor model.
5. Hedge funds use multifactor model to search for Arbitrage opportunities as they take
positions, prices to move towards equilibrium to estimate the arbitrage opportunities.
6. Sometimes there model get equilibrium long & lose money.
  Treynor Ratio:
DATA:
r M =¿ r f =¿

Managers Average Annual Beta

Return

TO FIND:
Treynor Ratio =?

SOLUTION:

T =E(r) −r f ÷ β

Manager A

T A= ( – ) /

T A= /

TA=

Manager B
T B= (–) /
T B= /

TB =

Manager C
T C= (– ) /

T C= /

TC =

INTERPRETATIOIN:

 Sharpe ratio:
DATA:

TO FIND:

SOLUTION:

S A =E(r)−r f ÷ σ (r )
Manager A
S A = (–) /

S A= /

SA =

Manager B
S B= ( – ) /

S B= /

SB =

Manager C
SC = ( – ) /

SC = /

SC =

INTERPRETATION:
  Jensen’s alpha:
DATA:

TOFIND:

SOLUTION:

A
J=E(r )−[r f + ( E (rM )−r f ) β❑ ]

J=−¿

J=−¿

J=−¿

J=¿

B
J=E(r )−[r f + ( E (rM )−r f ) β❑ ]

J=−¿

J=−¿

J=−¿
J=¿

C
J=E(r )−[r f + ( E (rM )−r f ) β❑ ]

J=−¿

J=−¿

J=−¿

J=¿

INTERPRETATION:

 Geometric Mean:

Geometric Mean = [(1+R1) × (1+R2) × (1+R3)…× (1+Rn)] 1/n−1

= [(+) ( + ) ( + ) ( + )] 1/ -1

= [( )( )( )( )] 1 -1

=[ ]1 -1
 = -1

=
= % Answer

STATE OF PROBABILITY: RA RB RC
ECONOMY:

Depression

Recession

Normal

Boom

 Expected Return:
 Ŕ A =R DEP × P DEP + R RESS × P RESS + R NORM × P NORM + R BOOM × PBOOM
Ŕ B=R DEP × P DEP + R RESS × P RESS + R NORM × P NORM + RBOOM × PBOOM
ŔC =R DEP × P DEP+ R RESS × PRESS + R NORM × P NORM + R BOOM × P BOOM

 Standard Deviation:

σ A =√ (R DEP− Ŕ A )2 PDEP +(RRESS − Ŕ A )2 PRESS +(R NORM − Ŕ A )2 P NORM +(R BOOM − Ŕ A )2 P BOOM

σ A =√ ¿ ¿ ¿

 Covariance:

Covariance (A, B) = PDEP (RDEP- Ŕ a) (RDEP- Ŕ b) + PRESS (RRESS- Ŕ a) (RRESS- Ŕ b) +PNORM (RNORM- Ŕ a) (RNORM- Ŕ b)
+PBOOM (RBOOM- Ŕ a) (RBOOM- Ŕ b)

 COREALTION COFICIENT
CORV = COV ÷ σ A σ B

 Variance
Variance= Wa2S.Da2+Wb2S.Db2+2WaWbCov (a, b)