Sun Daero college

Distance and continuing education

Program degree

Department of accounting and finance

Course title: INVESTMENT ANALYSIS AND PORTFLIO
MANAGEMENT

Course code ACFN 4052

Cr.hr 3

JULY.2022
 CHAPTER ONE
INTRODUCTION TO INVESTMENT

Saving; the purpose of savings is to develop financial security, once an appropriate amount of
liquid assets are reached, recommend refocusing goals from saving to investing,

1.1 What is investment?

Investment is the employment of funds on assets with aim of earning income or capital
appreciation. Investment is the commitment of money or capital to the purchase of financial
instruments or other assets so as to gain profitable returns in the form of interest, income
(dividends), or appreciation (capital gains) of the value of the instrument.

Investment is involved in many areas of the economy, such as business management and finance
no matter for households, firms, or governments. An investment involves the choice by an
individual or an organization, such as a pension fund, after some analysis or thought, to place or
lend money in a vehicle, instrument or asset, such as property, commodity, stock, bond, financial
derivatives (e.g. futures or options), or the foreign asset denominated in foreign currency, that
has certain level of risk and provides the possibility of generating returns over a period of time.

● Purchase of assets with the goal of increasing future income

● Focuses on wealth accumulation

● Appropriate for long-term goals

Risk- uncertainty regarding the outcome of a situation or event

Investment Risk: - possibility that an investment will fail to pay the expected return or fail to
pay a return at all. All investment tools carry some level of risk

Inflation: - rise in the general level of prices

Inflation Risk: - The danger that money won’t be worth as much in the future as it is today.
Inflation risk is usually not a concern with savings since the goal of savings is to provide current
financial security

1.2 Investment Alternatives

Economic Investment and Financial Investment

Economic or real asset investment can be defined as the investment that contributes to the net
additions to the capital stock of society. Capital stock refers to the goods and service that are
used in the production of other goods and services. When a person invests his funds for the
acquisition of some physical assets, say a building or equipment, such types of investments are
called economic investments. Hence, in short, it can be said that economic investments help
create physical assets dir2ectly.

Financial Asset Investment: - When a person invests his funds for the acquisition of some
financial assets like shares, debentures, insurance policies, mutual fund units etc, and such
investments are known as financial investments. Financial investments also help in creating
physical assets, but indirectly. Hence, economic investment and financial investment are inter-
related. Increase in financial investment leads to increase in capital stock. When an investor
invests in a financial asset, he indirectly invests in an underlying physical asset, since the
financial investments are ultimately used in creation of physical

INVETMENT V/s SPECULATION

Both investment and speculation are somewhat interrelated. It is said that speculation requires
investment and investments are to some extent speculative. Speculation is the purchase or sale of
anything in the hope of profit from anticipated changes in price. Both investment and speculation
aim at realizing income and capital appreciation. Yet, differences exist in terms of expectation,
risk and period of time.

Investment Speculation
The investor invest for long The investor invest for short
term gain purpose term gain purpose
The investor holds securities The investor hold securities very
for long period. short period say 1 or 2 days
Risk is less as compare to Risk is high
speculation Rate of return is more
The rate of return is less as It involve buying and selling of
compare to speculation securities

GAMBLING

As against investment and speculation, gambling is unplanned. A gamble is usually a very short term
investment in a game or chance. It is an act of creating artificial and unnecessary risks for expected
increased return. Gambling is undertaken just for trill and excitement. There is no risk and return trade off
in the gambling and the negative outcomes are expected. But in the investment there is an analysis of risk
and return. In short, gambling involves acceptance of extraordinary risks even without a thorough
knowledge about them for pecuniary gains. Horse racing, playing cards, lottery etc.

INVESTMENT PROCESS

The investment process involves a series of activities leading to the purchase of securities or other
investment alternatives. The investment process can be divided into the following stages.
 PORTFOLI PORTFOL
INVESTME VALUATI O IO
ANALYSIS
NT POLICY ON CONSTRUCTI EVALUAT
ON ION
Investable Diversifica
fund Intrinsic tion
Objective Market Selection Apprais
value
s Industry Future & al
Knowled Company value Allocatio Revision
ge n
DIFFERENT ALTERNATIVES FOR INVESTMENT

Investment in any of the alternatives depends on the needs and requirements of the investor.
Corporate and individuals have different needs. Before investing, these alternatives of
investments need to be analyzed in terms of their risk, return, term, convenience, liquidity etc.

Equity Shares:

Equity investments represent ownership in a running company. By ownership, we mean share in

the profits and assets of the company but generally, there are no fixed returns. It is considered as
a risky investment but at the same time, they are most liquid investments due to presence of
stock markets

Debentures or Bonds:

Debentures or bonds are long term investment options with a fixed stream of cash flows
depending on the quoted rate of interest. They are considered relatively less risky. Amount of
risk involved in debentures or bonds is dependent upon who the issuer is. For example, if the
issuer is government, the risk is assumed to be zero. Following alternatives are available under
debentures or bonds:

 Government securities

 Savings bonds

 Public Sector Units bonds

 Debentures of private sector companies

 Preference shares

Money Market Instruments:

Money market instruments are just like the debentures but the time period is very less. It is
generally less than 1 year. Corporate entities can utilize their idle working capital by investing in
money market instruments. Some of the money market instruments are

 Treasury Bills

 Commercial Paper

 Certificate of Deposits

Mutual Funds:

Mutual funds are an easy and tension free way of investment and it automatically diversifies the
investments. Mutual fund is an investment mix of debts and equity and ratio depending on the
scheme. They provide with benefits such as professional approach, benefits of scale and
convenience. In mutual funds also, we can select among the following types of portfolios:

 Equity Schemes

 Debt Schemes

 Balanced Schemes

 Sector Specific Schemes etc.

1.3 investment companies

DEFINITION: A type of financial intermediary who obtain funds from investing to use in
purchase of financial assets. Eg. Mutual fund companies, investment banks, insurance companies
etc

▫ investors receive certain rights in exchange

▫ Advantages to the Individual Investor

 economies of scale(higher volume purchases, lower commission rate)

 provides diversification

 professional management (manager is a professional seeking mispriced

securities full time)

1.4 security market

What is a market?

• Brings buyers and sellers together to aid in the transfer of goods and services

• Does not require a physical location

• Both buyers and sellers benefit from the market

A security market is used in an economy to attract new capital, transfer real asset in financial
assets, determine price which will balance demand and supply and provide a means to invest
money both short and long term.

Securities are financial instruments issued to raise funds. The primary function of the security
market is to enhance the flow of capital from those that have it to those that need it.

Security market helps in transfer of resource from those which idle resource to other who have a
productive need for them.

Security market is a component of the wider financial market where security can be bought and
sold between the subjects of the economy on the basis of dd and ss.

Primary market: where new security are issued

Secondary market: where existing security can be sold and bought

The most well known examples of includes in security market are stocks and bonds

Examples of security are broadly categorized in to: debt security like bank notes, bonds,
debentures.

Equity securities like the common stock.

CHAPTER TWO

RISK AND RETURN

The purpose of this chapter is to help you understand how to choose among alternative
investment assets. This selection process requires that you estimate and evaluate the expected
risk-return trade-offs for the alternative investments available. Therefore, you must understand
how to measure the rate of return and the risk involved in an investment accurately. To meet this
need, in this section we examine ways to quantify return and risk. The presentation will consider
how to measure both historical and expected rates of return and risk.

Therefore, when we talk about a return on an investment, we are concerned with the change in
wealth resulting from this investment. This change in wealth can be either due to cash inflows,
such as interest or dividends, or caused by a change in the price of the asset (positive or
negative).

Albert Einstein Credited for discovering the mathematical equation for compounding interest,
thus the “Rule of 72.” At 10% interest rate, money doubles every 7.2 years, A=P(1+i)n

Assumptions of rule of 72

● Only an approximation
● Interest rate must remain constant
● Interest rate is not converted to a decimal
● Equation does not allow for additional payments to be made to the original amount
● Interest earned is reinvested
● Tax deductions are not included

Doug’s Certificate of Deposit

Doug invested $2,500 into a Certificate of Deposit earning a 6.5% interest rate. How long
will it take Doug’s investment to double

● Invested $2,500

Interest Rate is 6.5% then 72/6.5 = 11 years to double

Jessica’s Credit Card Debt

Jessica has a $2,200 balance on her credit card with an 18% interest rate. If Jessica chooses
to not make any payments and does not receive late charges, how long will it take for her
balance to double?

● $2,200 balance on credit card

● 18% interest rate

72/18 =4 years

Jacob’s Car
 Jacob currently has $5,000 to invest in a car after graduation in 4 years. What interest rate is
required for him to double his investment?

● $5,000 to invest

Wants investment to double in 4 years

72/4 =18% interest rate

2.2 Measures of Historical Rates of Return

The first measure is the historical rate of return on an individual investment over the time period
the investment is held (that is, its holding period). Next, we consider how to measure the average
historical rate of return for an individual investment over a number of time periods. The third
subsection considers the average rate of return for a portfolio of investments.

If you commit $200 to an investment at the beginning of the year and you get back $220 at the
end of the year, what is your return for the period? The period during which you own an
investment is called its holding period, and the return for that period is the holding period return
(HPR). In this example, the HPR is 1.10, calculated as follows:

HPR = Ending Value of Investment/Beginning Value of Investment

HPR=$$220/200 = 1.10

This value will always be zero or greater—that is, it can never be a negative value. A value
greater than 1.0 reflects an increase in your wealth, which means that you received a positive rate
of return during the period. A value less than 1.0 means that you suffered a decline in wealth,
which indicates that you had a negative return during the period. An HPR of zero indicates that
you lost all your money.

Although HPR helps us express the change in value of an investment, investors generally
evaluate returns in percentage terms on an annual basis. This conversion to annual percentage
rates makes it easier to directly compare alternative investments that have markedly different
characteristics. The first step in converting of HPR to an annual percentage rate is to derive a
percentage return, referred to as the holding period yield (HPY). The HPY is equal to the HPR
minus 1.

HPY =HPR – 1
 In our example: HPY =1.10 – 1 =0.10 =10

To derive an annual HPY, you compute an annual HPR and subtract 1. Annual HPR is found by:

➤1.3 Annual HPR =HPR1/n

where:

n=number of years the investment is held

Consider an investment that cost $250 and is worth $350 after being held for two years:

HPR= Ending Value of Investment/Beginning Value of Investment= 350/250 =1.40

Annual HPR = HPR 1/ n

=1.4 1/ 2

Annual HPY = 1.1832-1 = 18.32%

Note that we made some implicit assumptions when converting the HPY to an annual basis. This
annualized holding period yield computation assumes a constant annual yield for each year. In
the two-year investment, we assumed an 18.32 percent rate of return each year, compounded. In
the partial year HPR that was annualized, we assumed that the return is compounded for the
whole year. That is, we assumed that the rate of return earned during the first part of the year is
likewise earned on the value at the end of the first six months. The 12 percent rate of return for
the initial six months compounds to 25.44 percent for the full year. Because of the uncertainty of
being able to earn the same return in the future six months, institutions will typically not
compound partial year results.

Remember one final point: The ending value of the investment can be the result of a positive or
negative change in price for the investment alone (for example, a stock going from $20 a share to
$22 a share), income from the investment alone, or a combination of price change and income.
Ending value includes the value of everything related to the investment.

Computing Mean Historical Returns

Now that we have calculated the HPY for a single investment for a single year, we want to
consider mean rates of return for a single investment and for a portfolio of investments. Over
number of years, a single investment will likely give high rates of return during some years and
low rates of return, or possibly negative rates of return, during others. Your analysis should
consider each of these returns, but you also want a summary figure that indicates this
investment’s typical experience, or the rate of return you should expect to receive if you owned
this investment over an extended period of time. You can derive such a summary figure by
computing the mean annual rate of return for this investment over some period of time.

Alternatively, you might want to evaluate a portfolio of investments that might include similar
investments (for example, all stocks or all bonds) or a combination of investments (for example,
stocks, bonds, and real estate). In this instance, you would calculate the mean rate of return for
this portfolio of investments for an individual year or for a number of years.

Single Investment Given a set of annual rates of return (HPYs) for an individual investment,
there are two summary measures of return performance. The first is the arithmetic means return,
the second the geometric mean return. To find the arithmetic mean (AM), the sum (∑) of annual
HPYs is divided by the number of years (n) as follows:

➤2.4 AM =∑HPY/n

Where: ∑HPY =the sum of annual holding period yields

An alternative computation, the geometric mean (GM), is the nth root of the product of the HPRs
for n years.

➤2.5 GM =¿

where: = π the product of the annual holding period returns as follows;

(HPR1) ×(HPR2)......(HPRn)

AM =[(0.15) +(0.20) +(–0.20)]/3

=0.15/3
 =0.05 =5%

GM =[(1.15) ×(1.20) ×(0.80)]1/3 – 1

=(1.104)1/3– 1

=1.03353 – 1

=0.03353 =3.353%

Investors are typically concerned with long-term performance when comparing alternative
investments. GM is considered a superior measure of the long-term mean rate of return because
it indicates the compound annual rate of return based on the ending value of the investment
versus its beginning value. Specifically, using the prior example, if we compounded 3.353
percent for three years, (1.03353) , we would get an ending wealth value of 1.104. Although the
arithmetic average provides a good indication of the expected rate of return for an investment
during a future individual year, it is biased upward if you are attempting to measure an asset’s
long-term performance. This is obvious for a volatile security. Consider, for example, a security
that increases in price from $50 to $100 during year 1 and drops back to $50 during year 2. The
annual HPYs would be: Investors are typically concerned with long-term performance when
comparing alternative investments. GM is considered a superior measure of the long-term mean
rate of return because it indicates the compound annual rate of return based on the ending value
of the investment versus its beginning value. Specifically, using the prior example, if we
compounded 3.353 percent for three years, (1.03353), we would get an ending wealth value of
1.104.

Although the arithmetic average provides a good indication of the expected rate of return for an
investment during a future individual year, it is biased upward if you are attempting to measure
an asset’s long-term performance. This is obvious for a volatile security. Consider, for example,
a security that increases in price from $50 to $100 during year 1 and drops back to $50 during
year 2. The annual HPYs would be:
This would give an AM rate of return of:

[(1.00) + (–0.50)]/2 =.50/2

=0.25 =25%

This investment brought no change in wealth and therefore no return, yet the AM rate of return is
computed to be 25 percent.

The GM rate of return would be:

(2.00 ×0.50)1/2 – 1 = (1.00)1/2– 1 = 1.00 – 1 =0%

This answer of a 0 percent rate of return accurately measures the fact that there was no change in
wealth from this investment over the two-year period. When rates of return are the same for all
years, the GM will be equal to the AM. If the rates of return vary over the years, the GM will
always be lower than the AM. The difference between the two mean values will depend on the
year-to-year changes in the rates of return. Larger annual changes in the rates of return—that is,
more volatility—will result in a greater difference between the alternative mean values.

An awareness of both methods of computing mean rates of return is important because published
accounts of investment performance or descriptions of financial research will use both the AM
and the GM as measures of average historical returns. We will also use both throughout this
book. Currently most studies dealing with long-run historical rates of return include both AM
and GM rates of return.

Arithmetic vs. Geometric Averages

• When rates of return are the same for all years, the AM and the GM will be equal.

• When rates of return are not the same for all years, the AM will always be higher
than the GM.

While the AM is best used as an “expected value” for an individual year, while the GM is the
best measure of an asset’s long-term performance

A Portfolio of Investments The mean historical rate of return (HPY) for a portfolio of
investments is measured as the weighted average of the HPYs for the individual investments in
the portfolio, or the overall change in value of the original portfolio. The weights used in
computing the averages are the relative beginning market values for each investment; this is
referred to as dollar-weighted or value-weighted mean rate of return.

This technique is demonstrated by the examples in. As shown, the HPY is the same (9.5 percent)
whether you compute the weighted average return using the beginning market value weights or if
you compute the overall change in the total value of the portfolio.

Although the analysis of historical performance is useful, selecting investments for your
portfolio requires you to predict the rates of return you expect to prevail. The next section
discusses how you would derive such estimates of expected rates of return. We recognize the
great uncertainty regarding these future expectations, and we will discuss how one measures this
uncertainty, which is referred to as the risk of an investment.

Risk is the uncertainty that an investment will earn its expected rate of return. Any investor,
before investing his investable wealth in the asset, analyses the risk associated with the particular
asset. The actual return he receives from an asset may vary from his expected return and the risk

is expected in terms of variability of return. The dictionary meaning of risk is the possibility of
loss or injury. In risk, the probable outcomes of all possible events are listed. Once the events are
listed subjectively, the derived probabilities can be assigned to the entire possible events.
2.3 Measuring Historical Risk

In the examples in the prior section, we examined realized historical rates of return. To measure
the risk for a series of historical rates of returns, except that we consider the historical holding
period yields (HPYs) as follows In contrast, an investor who is evaluating a future investment
alternative expects or anticipates a certain rate of return. The investor might say that he or she
expects the investment will provide a rate of return of 10 percent, but this is actually the
investor’s most likely estimate, also referred to as a point estimate. Pressed further, the investor
would probably acknowledge the uncertainty of this point estimate return and admit the
possibility that, under certain conditions, the annual rate of return on this investment might go as
low as –10 percent or as high as 25 percent. The point is, the specification of a larger range of
possible returns from an investment reflects the investor’s uncertainty regarding what the actual
return will be. Therefore, a larger range of expected returns makes the investment riskier.

These statistical measures allow you to compare the return and risk measures for alternative
investments directly. Two possible measures of risk (uncertainty) have received support in
theoretical work on portfolio theory: the variance and the standard deviation of the estimated
distribution of risk and return.

The standard deviation is the square root of the variance. Both measures indicate how much the
individual HPYs over time deviated from the expected value of the series.

Measuring the Risk of Expected Rates of Return

An investor determines how certain the expected rate of return on an investment is by analyzing
estimates of expected returns. To do this, the investor assigns probability values to all possible
returns. These probability values range from zero, which means no chance of the return, to one,
which indicates complete certainty that the investment will provide the specified rate of return.
These probabilities are typically subjective estimates based on the historical performance of the
investment or similar investments modified by the investor’s expectations for the future.

As an example, an investor may know that about 30 percent of the time the rate of return on this
particular investment was 10 percent. Using this information along with future expectations
regarding the economy, one can derive an estimate of what might happen in the future. The
expected return from an investment is defined as:

➤1.6 E(Ri) =[(P1)(R1) +(P2)(R2) + (P3)(R3) +...+(Pn Rn)]

Let us begin our analysis of the effect of risk with an example of perfect certainty wherein the
investor is absolutely certain of a return of 5 percent. Perfect certainty allows only one possible
return, and the probability of receiving that return is 1.0. Few investments provide certain
returns. In the case of perfect certainty, there is only one value for Pi x Ri:

E(Ri) =(1.0)(0.05) =0.05

In an alternative scenario, suppose an investor believed an investment could provide several

different rates of return depending on different possible economic conditions. As an example, in
a strong economic environment with high corporate profits and little or no inflation, the investor
might expect the rate of return on common stocks during the next year to reach as high as 20
percent. In contrast, if there is an economic decline with a higher-than-average rate of inflation,
the investor might expect the rate of return on common stocks during the next year to be –20
percent. Finally, with no major change in the economic environment, the rate of return during the
next year would probably approach the long-run average of 10 percent.

The expected rate of return for this investment is the same as the certain return discussed in the
first example; but, in this case, the investor is highly uncertain about the actual rate of return.
This would be considered a risky investment because of that uncertainty. We would anticipate
that an investor faced with the choice between this risky investment and the certain (risk-free)
case would select the certain alternative. This expectation is based on the belief that most
investors are risk averse, which means that if everything else is the same, they will select the
investment that offers greater certainty.
The expected rate of return for this investment is the same as the certain return discussed in the
first example; but, in this case, the investor is highly uncertain about the actual rate of return.
This would be considered a risky investment because of that uncertainty. We would anticipate
that an investor faced with the choice between this risky investment and the certain (risk-free)
case would select the certain alternative. This expectation is based on the belief that most
investors are risk averse, which means that if everything else is the same, they will select the
investment that offers greater certainty

We have shown that we can calculate the expected rate of return and evaluate the uncertainty, or
risk, of an investment by identifying the range of possible returns from that investment and
assigning each possible return a weight based on the probability that it will occur. Although the
graphs help us visualize the dispersion of possible returns, most investors want to quantify this
dispersion using statistical techniques. These statistical measures allow you to compare the
return and risk measures for alternative investments directly. Two possible measures of risk
(uncertainty) have received support in theoretical work on portfolio theory: the variance and the
standard deviation of the estimated distribution of expected returns.

In this section, we demonstrate how variance and standard deviation measure the dispersion of
possible rates of return around the expected rate of return. We will work with the examples
discussed earlier. The formula for variance is as follows

Variance The larger the variance for an expected rate of return, the greater the dispersion of
expected returns and the greater the uncertainty, or risk, of the investment. The variance for the
perfect-certainty example would be

Note that, in perfect certainty, there is no variance of return because there is no deviation from
expectations and, therefore, no risk or uncertainty. The variance for the second example would
be:

Standard Deviation The standard deviation is the square root of the variance:
Therefore, when describing this example, you would contend that you expect a return of 7
percent, but the standard deviation of your expectations is 11.87 percent. A Relative Measure of
Risk In some cases, an unadjusted variance or standard deviation can be misleading. If
conditions for two or more investment alternatives are not similar—that is, if there are major
differences in the expected rates of return—it is necessary to use a measure of relative variability
to indicate risk per unit of expected return. A widely used relative measure of risk is the
coefficient of variation (CV), calculated as follow

This measure of relative variability and risk is used by financial analysts to compare alternative
investments with widely different rates of return and standard deviations of returns.

As an illustration, consider the following two investments:

CVA = 0.05/0.07= 0.714

CVB = 0.07/0.12 = 0.583

Comparing absolute measures of risk, investment B appears to be riskier because it has a

standard deviation of 7 percent versus 5 percent for investment A. In contrast, the CV figures
show that investment B has less relative variability or lower risk per unit of expected return
because it has a substantially higher expected rate of return:
 Determinants of Risk

Because differences in yields result from the riskiness of each investment, you must understand
the risk factors that affect the required rates of return and include them in your assessment of
investment opportunities. Because the required returns on all investments change over time, and
because large differences separate individual investments, you need to be aware of the see the
real risk-free rate (RRFR) is the basic interest rate, assuming no inflation and no uncertainty
about future flows. An investor in an inflation-free economy who knew with certainty what cash
flows he or she would receive at what time would demand the RRFR on an investment. Earlier,
we called this the pure time value of money, because the only sacrifice the investor made was
deferring the use of the money for a period of time. This RRFR of interest is the price charged
for the exchange between current goods and future goods.

Two factors, one subjective and one objective, influence this exchange price. The subjective
factor is the time preference of individuals for the consumption of income. When individuals
give up $100 of consumption this year, how much consumption do they want a year from now to
compensate for that sacrifice? The strength of the human desire for current consumption
influences the rate of compensation required. Time preferences vary among individuals, and the
market creates a composite rate that includes the preferences of all investors. This composite rate
changes gradually over time because it is influenced by all the investors in the economy, whose
changes in preferences may offset one another.

The objective factor that influences the RRFR is the set of investment opportunities available in
the economy. The investment opportunities are determined in turn by the long-run real growth
rate of the economy. A rapidly growing economy produces more and better opportunities to
invest funds and experience positive rates of return. A change in the economy’s long-run real
growth rate causes a change in all investment opportunities and a change in the required rates of
return on all investments. Just as investors supplying capital should demand a higher rate of
return when growth is higher, those looking for funds to invest should be willing and able to pay
a higher rate of return to use the funds for investment because of the higher growth rate. Thus, a
positive relationship exists between the real growth rate in the economy and the RRFR. veral
components that determine the required rate of return, starting with the risk-free rate. Earlier, we
observed that an investor would be willing to forgo current consumption in order to increase
future consumption at a rate of exchange called the risk-free rate of interest. This rate of
exchange was measured in real terms because the investor wanted to increase the consumption of
actual goods and services rather than consuming the same amount that had come to cost more
money. Therefore, when we discuss rates of interest, we need to differentiate between real rates
of interest that adjust for changes in the general price level, as opposed to nominal rates of
interest that are stated in money terms. That is, nominal rates of interest that prevail in the market
are determined by real rates of interest, plus factors that will affect the nominal rate of interest,
such as the expected rate of inflation and the monetary environment. It is important to understand
these factors.

Risk Premium and Portfolio Theory

A risk-free investment was defined as one for which the investor is certain of the amount and
timing of the expected returns. The returns from most investments do not fit this pattern. An
investor typically is not completely certain of the income to be received or when it will be
received. Investments can range in uncertainty from basically risk-free securities, such as T-bills,
to highly speculative investments, such as the common stock of small companies engaged in
high-risk enterprises. Most investors require higher rates of return on investments if they
perceive that there is any uncertainty about the expected rate of return. This increase in the
required rate of return over the NRFR is the risk premium (RP). Although the required risk
premium represents a composite of all uncertainty, it is possible to consider several fundamental
sources of uncertainty. In this section, we identify and discuss briefly the major sources of
uncertainty, including: (1) business risk, (2) financial risk (leverage), (3) liquidity risk, (4)
exchange rate risk, and (5) country (political) risk. Some might expect a conflict between the
market measure of risk (systematic risk) and the fundamental determinants of risk (business risk,
and so on). A number of studies have examined the relationship between the market measure of
risk (systematic risk) and accounting variables used to measure the fundamental risk factors,
such as business risk, financial risk, and liquidity risk.

The authors of these studies have generally concluded that a significant relationship exists
between the market measure of risk and the fundamental measures of risk.

Therefore, the two measures of risk can be complementary. This consistency seems reasonable
because, in a properly functioning capital market, the market measure of the risk should reflect
the fundamental risk characteristics of the asset. As an example, you would expect a firm that has
high business risk and financial risk to have an above average beta. At the same time, as we
discuss it is possible that a firm that has a high level of fundamental risk and a large standard
deviation of return on stock can have a lower level of systematic risk because its variability of
earnings and stock price is not related to the aggregate economy or the aggregate market.
Therefore, one can specify the risk premium for an asset as:

NRFR =(1 +RRFR) ×(1 +Expected Rate of Inflation) – 1

Summary

The purpose of chapter 1and 2 is to provide background that can be used in subsequent chapters.
To achieve that goal, we covered several topics:

• We discussed why individuals save part of their income and why they decide to invest their
savings. We defined investment as the current commitment of these savings for a period of time
to derive a rate of return that compensates for the time involved, the expected rate of inflation,
and the uncertainty.

• We examined ways to quantify historical return and risk to help analyze alternative investment
opportunities. We considered two measures of mean return (arithmetic and geometric) and
applied these to a historical series for an individual investment and to a portfolio of investments
during a period of time.

• We considered the concept of uncertainty and alternative measures of risk (the variance,
standard deviation, and a relative measure of risk—the coefficient of variation).

• Before discussing the determinants of the required rate of return for an investment, we noted

that the estimation of the required rate of return is complicated because the rates on individual

investments change over time, because there is a wide range of rates of return available on
alternative investments, and because the differences between required returns on alternative
investments.
 CHAPTER -3

FIXED INCOME SECURITIES

Definition of fixed income securities

Fixed income securities refers to all securities that provide or promise to provide contractual payments
during their lifetime fixed income securities often make regular payments of interest, for example bonds
notes some money instruments preferred stock.

Bond issues are considered fixed-income securities because they impose fixed financial obligations on the
issuers. Specifically, the issuer agrees to:-

1. Pay a fixed amount of interest periodically to the holder of record

2. Repay a fixed amount of principal at the date of maturity

Normally, interest on bonds is paid every six months, although some bond issues pay in intervals as short
as a month or as long as a year.
The public debt market typically is divided into three time segments based on an issue’s original maturity:

1. Short-term issues with maturities of one year or less. The market for these instruments is
commonly known as the money market.

2. Intermediate-term issues with maturities in excess of 1 year but less than 10 years. These
instruments are known as notes.

3. Long-term obligations with maturities in excess of 10 years, called bonds

3.1Bond Characteristics

Intrinsic Features: The coupon, maturity, principal value, and the type of ownership are important
intrinsic features of a bond.

The coupon of a bond indicates the income that the bond investor will receive over the life (or holding
period) of the issue. This is known as interest income, coupon income, or nominal yield.

The term to maturity specifies the date or the number of years before a bond matures (or expires).

There are two different types of maturity. The most common is a term bond, which has a single maturity
date. Alternatively, a serial obligation bond issue has a series of maturity dates, perhaps 20 or 25. Each
maturity, although a subset of the total issue, is really a small bond issue with generally a different
coupon. Municipalities issue most serial bonds.

The principal ,or par value, of an issue represents the original value of the obligation.

3.2 Bond pricing

Because a bond’s coupon and principal repayments all occur months or years in the future, the
price an investor would be willing to pay for a claim to those payments depends on the value of
dollars to be received in the future compared to dollars in hand today. This “present value”
calculation depends in turn on market interest rates. As we saw in Chapter 5,the nominal risk-
free interest rate equals the sum of (1) a real risk-free rate of return and (2)a premium above the
real rate to compensate for expected inflation. In addition, because most bonds are not riskless,
the discount rate will embody an additional premium that reflects bond-specific characteristics
such as default risk, liquidity, tax attributes, call risk, and so on.

We simplify for now by assuming there is one interest rate that is appropriate for discounting
cash flows of any maturity, but we can relax this assumption easily. In practice, there may be
different discount rates for cash flows accruing in different periods. For the time being, however,
we ignore this refinement.
To value a security, we discount its expected cash flows by the appropriate discount rate. The
cash flows from a bond consist of coupon payments until the maturity date plus the final
payment of par value. Therefore,

Bond value ==Present value of coupons +Present value of par value

3.3. Bond yield

We have noted that the current yield of a bond measures only the cash income provided by the
bond as a percentage of bond price and ignores any prospective capital gains or losses. We
would like a measure of rate of return that accounts for both current income and the price
increase or decrease over the bond’s life. The yield to maturity is the standard measure of the
total rate of return. However, it is far from perfect, and we will explore several variations of this
measure.

In practice, an investor considering the purchase of a bond is not quoted a promised rate of
return. Instead, the investor must use the bond price, maturity date, and coupon payments to infer
the return offered by the bond over its life. The yield to maturity (YTM) is defined as the interest
rate that makes the present value of a bond’s payments equal to its price. This interest rate is
often viewed as a measure of the average rate of return that will be earned on a bond if it is
bought now and held until maturity. To calculate the yield to maturity, we solve the bond price
equation for the interest rate given the bond’s price.

3.4 Risk in bond and bond rating

Although bonds generally promise a fixed flow of income, that income stream is not riskless
unless the investor can be sure the issuer will not default on the obligation. While U.S.
government bonds may be treated as free of default risk, this is not true of corporate bonds.
Therefore, the actual payments on these bonds are uncertain, for they depend to some degree on
the ultimate financial status of the firm.

Bond default risk, usually called credit risk, is measured by Moody’s Investor Services, Standard
& Poor’s Corporation, Duff & Phelps, and Fitch Investors Service, all of which provide financial
information on firms as well as quality ratings of large corporate and municipal bond issues.
Each firm assigns letter grades to the bonds of corporations and municipalities to reflect their
assessment of the safety of the bond issue. The top rating is AAA or Aaa. Moody’s modifies
each rating class with a 1, 2, or 3 suffix (e.g., Aaa1, Aaa2, Aaa3)to provide a finer gradation of
ratings. The other agencies use a +or-modification.
3.4 Analysis of Convertible Bonds

Convertible bonds give bondholders an option to exchange each bond for a specified number of
shares of common stock of the firm. The conversion ratio is the number of shares for which each
bond may be exchanged. Suppose a convertible bond is issued at par value of $1,000 and is
convertible into 40 shares of a firm’s stock. The current stock price is $20 per share, so the
option to convert is not profitable now. Should the stock price later rise to $30, however, each
bond may be converted profitably into$1,200 worth of stock. The market conversion value is the
current value of the shares for which the bonds may be exchanged. At the $20 stock price, for
example, the bond’s conversion value is $800. The conversion premium is the excess of the bond
value over its conversion value. If the bond were selling currently for $950, its premium would
be $150.

Convertible bondholders benefit from price appreciation of the company’s stock. Again, this
benefit comes at a price: Convertible bonds offer lower coupon rates and stated or promised
yields to maturity than do nonconvertible bonds. However, the actual return on the convertible
bond may exceed the stated yield to maturity if the option to convert becomes profitable.
 Chapter 4
Stock and equity valuation
4.1 What are stocks?
• Stocks represent ownership capital
• Stockholders are part owners of the company
4.2 Characteristics of a stock
– Claim on income
– Claim on Assets
– Voting Rights
– Preemptive Rights-
– Limited Liability
Common stockholders are residual claimants.
No claim to earnings or assets until all senior claims are paid in full or
they have the last claim on the assets of the firm after paying off
creditors and bond holders and preferred stockholders.
Stockholders have voting rights on important company decisions.
Debt and equity have substantially different marginal benefits and
marginal costs.
Preferred Stock
Preferred stock is a hybrid having some features similar to debt and
other features similar to equity.
– Claim on assets and cash flow senior to common stock
– As equity security, dividend payments are not tax deductible
for the corporation.
– For tax reasons, straight preferred stock held mostly by
corporations.
Promises a fixed annual dividend payment, but not legally enforceable,
Firms cannot pay common stock dividends if preferred stock is in arrears
(i.e. preferred stock is typically “cumulative”)
- Preferred stockholders usually do not have voting rights.
- May be convertible to common stock.
Example 5.1: Valuing preferred
• You purchase a preferred stock with a $12 per year dividend. For
a 10% market rate, what is its value?

D1 $ 12
Price = PV = = = $ 120 . 00
i 0. 10

Common Stock
Market capitalization- Market price per share x number of shares
outstanding
Treasury stock- Stock repurchased by corporation; usually purchased
for stock options
Stock split- Two-for-one split issues one new share for each already
held; reduces per share price. e.g. A stock selling for $50 per share will
sell for $25 per share after a 2 for 1 stock split
Stock Valuation
• Like other assets in finance, the value of a stock is the PV of its
CF’s
• Stocks are typically valued as perpetual securities as corporations
potentially have an infinite life, and thus can pay dividends
forever.
How to make money in the stock market
1. The standard answer – “Buy Low, Sell High” i.e. Earn capital
gains
2. From dividends – Over the long run, historically speaking almost
½ of the total return to stock market investors was from dividends.
 CHAPTER 5

A STUDY ON FUNDAMENTAL AND TECHNICAL ANALYSIS

INTRODUCTION

Fundamental analysis is the examination of the underlying forces that affect the well being of the
economy, industry groups and companies. As with most analysis, the goal is to develop a
forecast of future price movement and profit from it. At the company level, fundamental analysis
may involve examination of financial data, management, business concept and competition. At
the industry level, there might be an examination of supply and demand forces of the products.
For the national economy, fundamental analysis might focus on economic data to assess the
present and future growth of the economy.

To forecast future stock prices, fundamental analysis combines economic, industry, and company
analysis to derive a stock’s fair value called intrinsic value. If fair value is not equal to the
current stock price, fundamental analysts believe that the stock is either over or under valued. As
the current market price will ultimately gravitate towards fair value, the fair value should be
estimated to decide whether to buy the security or not. By believing that prices do not accurately
reflect all available information, fundamental analysts look to capitalize on perceived price
discrepancies.

Fundamental Analysis is a method of evaluating a security by attempting to measure its

intrinsic value by examining related economic, financial and other qualitative and quantitative
factors. Fundamental analysts attempt to study everything that can affect the security’s value,
including macroeconomic factors (like the overall economy and industry conditions) and
individual specific factors (like the financial condition and management of companies).

OBJECTIVES OF FUNDAMENTAL ANALYSIS

 To predict the direction of national economy because economic activity affects the corporate
profit, investor attitudes and expectation and ultimately security prices.

 To estimate the stock price changes by studying the forces operating in the overall economy,
as well as influences peculiar to industries and companies.

 To select the right time and right securities for the investment

THREE PHASES OF FUNDAMENTAL ANALYSIS

 1) Understanding of the macro-economic environment and developments (Economic
Analysis)
2) Analyzing the prospects of the industry to which the firm belongs (Industry Analysis)
3) Assessing the projected performance of the company (Company Analysis)

The three phase examination of fundamental analysis is also called as an EIC (Economy-
Industry-Company analysis) framework or a top-down approach-

Here the financial analyst first makes forecasts for the economy, then for industries and finally
for companies. The industry forecasts are based on the forecasts for the economy and in turn, the
company forecasts are based on the forecasts for both the industry and the economy. Also in this
approach, industry groups are compared against other industry groups and companies against
other companies. Usually, companies are compared with others in the same group.

For example, a telecom operator (Spice) would be compared to another telecom operator not to
an oil company.

Thus, the fundamental analysis is a 3 phase analysis of

a) The economy
b) The industry and
c) The company

Phase Nature of Purpose Tools and techniques

Analysis

FIRST Economic To access the general Economic indicators

Analysis economic situation of the

 nation.

SECOND To assess the prospects of Industry life cycle analysis,

Industry Analysis various industry groupings. Competitive analysis of

industries etc.

THIRD To analyse the Financial and Analysis of Financial

Company Analysis Non-financial aspects of a aspects: Sales,

company to determine Profitability, EPS etc.

whether to buy, sell or hold Analysis of Non-financial

the shares of a company. aspects: management,

corporate image, product

quality etc.

STRENGTHS OF FUNDAMENTAL ANALYSIS

 Long-term Trends

Fundamental analysis is good for long term investments based on long-term trends. The
ability to identify and predict long-term economic, demographic, technological or consumer
trends can benefit investors and helps in picking the right industry groups or companies.

 Value Spotting

Sound fundamental analysis will help identify companies that represent a good value.
Some of the most legendary investors think for long-term and value. Fundamental analysis can
help uncover the companies with valuable assets, a strong balance sheet, stable earnings, and
staying power.

 Business Acumen

One of the most obvious, but less tangible rewards of fundamental analysis is the
development of a thorough understanding of the business. After such painstaking research and
analysis, an investor will be familiar with the key revenue and profit drivers behind a
 company. Earnings and earnings expectations can be potent drivers of equity prices. A good
understanding can help investors avoid companies that are prone to shortfalls and identify
those that continue to deliver.

 Value Drivers

In addition to understanding the business, fundamental analysis allows investors to

develop an understanding of the key value drivers within the company. A stock’s price is heavily
influenced by the industry group. By studying these groups, investors can better position
themselves to identify opportunities that are high-risk (tech), low-risk (utilities), growth oriented
(computer), value driven (oil), non cyclical (consumer staples), cyclical (transportation) etc.

 Knowing Who is Who

Stocks move as a group. Knowing a company’s business, investors can better categorize
stocks within their relevant industry group that can make a huge difference in relative valuations.
The primary motive of buying a share is to sell it subsequently at a higher price. In many cases,
dividends are also to be expected. Thus, dividends and price changes constitute the return from
investing in shares. Consequently, an investor would be interested to know the dividend to be
paid on the share in the future as also the future price of the share. These values can only be
estimated and not predicted with certainty. These values are primarily determined by the
performance of the company which in turn is influenced by the performance of the industry to
which the company belongs and the general economic and socio-political scenario of the
country.

An investor who would like to be rational and scientific in his investment activity has to evaluate
a lot of information about the past performance and the expected future performance of
companies, industries and the economy as a whole before taking investment decision. Each share
is assumed to have an economic worth based on its present and future earning capacity. This is
called its intrinsic value or fundamental value. The purpose of fundamental analysis is to
evaluate the present and future earning capacity of a share based on the economy, industry and
company fundamentals and thereby assess the intrinsic value of the share. The investor can then
compare the intrinsic value of the share with the prevailing market price to arrive at an
investment decision. If the market price of the share is lower than its intrinsic value, the investor
would decide to buy the share as it is underpriced. The price of such a share is expected to move
up in future to match with its intrinsic value.

On the contrary, when the market price of a share is higher than its intrinsic value, it is perceived
to be overpriced. The market price of such a share is expected to come down in future and hence,
the investor would decide to sell such a share. Fundamental analysis thus provides an analytical
framework for rational investment decision-making. Fundamental analysis insists that no one
should purchase or sell a share on the basis of tips and rumours. The fundamental approach calls
upon the investor to make his buy or sell decision on the basis of a detailed analysis of the
information about the company, the industry to which the company belongs, and the economy.
This results in informed investing.

The fundamental analysis can be valuable, but it should be approached with caution. If you are
reading research written by a sell-side analyst, it is important to be familiar with the analyst
behind the report. We all have personal biases, and every analyst has some sort of bias. There is
nothing wrong with this, and the research can still be of great value. Learn what the ratings mean
and track the record of an analyst before jumping to a conclusion. Corporate statements and press
Releases of a company offer good information, but they should be read with a healthy degree of
skepticism to separate the facts from the spin. Press releases don’t happen by accident; they are
an important PR tool for companies. Investors should become skilled readers to weed out the
important information and ignore the hype.

TECHNICAL ANALYSIS

Fundamental analysis and Technical analysis are the two main approaches to security analysis.
Technical analysis is frequently used as a supplement to fundamental analysis rather than as a
substitute to it. According to technical analysis, the price of stock depends on demand and supply
in the market place. It has little correlation with the intrinsic value. All financial data and market
information of a given stock is already reflected in its market price.

Technical analysts have developed tools and techniques to study past patterns and predict future
price. Technical analysis is basically the study of the markets only. Technical analysts study the
technical characteristics which may be expected at market turning points and their objective
assessment. The previous turning points are studied with a view to develop some characteristics
that would help in identification of major market tops and bottoms. Human reactions are, by and
large consistent in similar though not identical reaction; with his various tools, the technician
attempts to correctly catch changes in trend and take advantage of them.

Technical analysis is directed towards predicting the price of a security. The price at which a
buyer and seller settle a deal is considered to be the one precise figure which synthesis, weighs
and finally expresses all factors, rational and irrational, quantifiable and non-quantifiable
and is the only figure that counts.

Thus, the technical analysis provides a simplified and comprehensive picture of what is
happening to the price of a security. Like a shadow or reflection it shows the broad outline of the
whole situation and it actually works in practice.

ASSUMPTIONS OF TECHNICAL ANALYSIS

 The market value of a security is solely determined by the interaction of demand and supply factors
operating in the market.

 The demand and supply factors of a security are surrounded by numerous factors; these factors are
both rational as well as irrational.

 The security prices move in trends or waves which can be both upward or downward depending upon
the sentiments, psychology and emotions of operators or traders.

 The present trends are influenced by the past trends and the projection of future trends is possible by
an analysis of past price trends.

 Except minor variations, stock prices tend to move in trends which continue to persist for an
appreciable length of time.

 Changes in trends in stock prices are caused whenever there is a shift in the demand and supply
factors.
 Shifts in demand and supply, no matter when and why they occur, can be detected through charts
prepared specially to show market action.

record
Some chart trends tend to repeat themselves. Patterns which are projected by charts
price movements and these patterns are used by technical analysis for making
forecasts about the future patterns.

TOOLS AND TECHNIQUES OF TECHNICAL ANALYSIS

There are numerous tools and techniques for doing technical analysis. Basically this analysis is
done from the following four important points of view:-

1) Prices: Whenever there is change in prices of securities, it is reflected in the changes in

investor attitude and demand and supply of securities.
2) Time: The degree of movement in price is a function of time. The longer it takes for a
reversal in trend, greater will be the price change that follows.

3) Volume: The intensity of price changes is reflected in the volume of transactions that
accompany the change. If an increase in price is accompanied by a small change in
transactions, it implies that the change is not strong enough.

4) Width: The quality of price change is measured by determining whether a change in

trend spreads across most sectors and industries or is concentrated in few securities only.
Study of the width of the market indicates the extent to which price changes have taken
place in the market in accordance with a certain overall trends.
 CHAPTER SIX
PORTFOLIO THEORY
Introduction
This chapter introduces three themes in portfolio theory, all centering on risk. The
first is the basic tenet that investors avoid risk and demand a reward for engaging
in risky investments. The reward is taken as a risk premium, the difference
between the expected rate of return and that available on alternative risk-free
investments.

The second theme allows us to quantify investors ‘personal trade-offs between

portfolio risk and expected return. To do this we introduce the utility function,
which assumes that investors can assign a welfare or “utility” score to any
investment portfolio depending on its risk and return. i.e investors need to rank
their portfolio investments.

Finally, the third fundamental principle is that we cannot evaluate the risk of an
asset separate from the portfolio of which it is a part; that is, the proper way to
measure the risk of an individual asset is to assess its impact on the volatility of the
entire portfolio of investments.
6.1 RISK AND RISK AVERSION

The presence of risk means that more than one outcome is possible.

An investment opportunity, in which a certain initial wealth is placed at risk, may

have two possible outcomes. For the sake of simplicity, it is useful to elucidate
some basic concepts using simple prospects.
Take as an example initial wealth, W, of $100,000, and assume two possible
results.
With a probability p =.6, the favorable outcome will occur, leading to final wealth
W1 =$150,000. Otherwise, with probability 1 _ p =.4, a less favorable outcome,
W2 =$80,000, will occur. We can represent the simple prospect using an event tree :

W=$150,000p =.6W1=$100,000

1 _ p =.4W2 =$80,000

Suppose an investor is offered an investment portfolio with a payoff in 1 year

describedby such a simple prospect. How can you evaluate this portfolio?
First, try to summarize it using descriptive statistics. For instance, the mean or
expectedend-of-year wealth, denoted E(W), is
E(W) =pW1 +(1 _ p)W2
=(.6 *150,000) +(.4 *80,000)
=$122,000

The standard deviation, (σ), which is the square root of the variance, is therefore
$34,292.86.
Clearly, this is risky business: The standard deviation of the payoff is large, much
larger than the expected profit of $22,000. Whether the expected profit is large
enough to justify such risk depends on the alternatives to this portfolio.

Let us suppose Treasury bills are one alternative to the risky portfolio. Suppose
that at the time of the decision, a 1-year T-bill offers a rate of return of 5%;
$100,000 can be invested to yield a sure profit of $5,000. We can now draw the
decision tree.
p =.6 profit =$50,000
A. invest in risky
prospect
1 _ p =.4 profit =$20,000

$100,000

B. Invest in risky
free T-bill
Profit=$5,000

Earlier we showed the expected profit on the prospect to be $22,000. Therefore,

the expected marginal, or incremental, profit of the risky portfolio over investing in
safe T-bills is
$22,000 _ $5,000 =$17,000

Meaning that one can earn a risk premium of $17,000 as compensation for the
risk of the investment

6.2 capital allocation between the risk asset and the risk free-asset

The capital allocation decision is the choice of the proportion of the overall
portfolio to place in safe but low-return money market securities versus risky but
higher return securities like stocks.
Usually this decision is made at a high organizational level. Individual investors typically follow
a less structured approach to money management

The most fundamental decision of investing is the allocations of your assets are the
following: How much should you own in stock?
How much should you own in bonds?
How much should you own in cash reserves?

For example, assume that the total market value of an initial portfolio is $300,000,
of which $90,000 is invested in the Ready Asset money market fund, a risk-free
asset for practical purposes. The remaining $210,000 is invested in risky securities
—$113,400 in equities (E) and $96,600 in long-term bonds (B). The equities and
long bond holdings comprise “the” risky portfolio, 54% in E and 46% in B:
E: W1=113400/210000=0.54
B:W2=96600/210000=0.46
The weight of the risky portfolio, P, in the complete portfolio, including risk-free
and risky investments, is denoted by y:
Y= 210000/300000 =0.7(RISKY ASSET)
1-Y =90000/300000 =0.3(RISK-FREE ASSET)
The weights of each stock in the complete portfolio are as follows:
E:113400/300000 = 0.378
B:96600/300000 = 0.322
TOTAL = 0.700
The risky portfolio is 70% of the complete portfolio.

Suppose that the owner of this portfolio wishes to decrease risk by reducing the
allocation
to the risky portfolio from y = .7 to y = .56. The risky portfolio would then total
only 0.56
* $300,000 = $168,000, requiring the sale of $42,000 of the original $210,000 of
risky
Holdings, with the proceeds used to purchase more shares in Ready Asset (the
money market
fund). Total holdings in the risk-free asset will increase to $300,000 * (1 - 0.56) =
$132,000, or the original holdings plus the new contribution to the money market
fund:
$90,000 +$42,000 =$132,000
The key point, however, is that we leave the proportions of each asset in the risky
portfolio
unchanged. Because the weights of E and B in the risky portfolio are .54 and .46,
respectively,
we sell .54 * $42,000 = $22,680 of E and .46 * $42,000 = $19,320 of B. After
the sale, the proportions of each asset in the risky portfolio are in fact unchanged:

E: w1=(113,400- 22,680)/(210,000- 42,000)=0.54

B: w2=(96,600-19,320)/210,000- 42,000)=0.46
but the complete portfolio will be changed to risky :0.56and the risk free
asset ;0.44

NB: Rather than thinking of our risky holdings E and B separately we may view
our holdings as if they were in a single fund as the probability distribution of the
rate of return on the risk portfolio remains unchanged by the asset allocation , but
there is a change in the complete portfolio that consists the risk and risk free asset

6.3 optimal risk portfolio

The optimal risk portfolio is to mean that it is an investor’s best combination of

risk asset to be mixed with safe asset to form the complete portfolio.
Diversification: Spreading a portfolio over many investments to avoid excessive
exposure to any one source of risk .When common sources of risk affect all firms,
however, even extensive diversification cannot eliminate risk. The risk that
remains even after extensive diversification is called market risk, risk that is
attributable to market wide risk sources. Such risk is also called systematic risk, or
no diversifiable risk. In contrast, the risk that canbe eliminated by diversification
is called unique risk, firm-specific risk, nonsystematic risk, or diversifiable
risk.
 CHAPTER SEVEN
ACTIVE PORTFOLIO MANAGEMENT

Equity portfolio management styles fall into either a passive or an active category.
Passive equity portfolio management is a long-term buy-and-hold strategy. That is a manger
selects a portfolio of bonds based on the objectives and constraints of the clients with the intent
of holding these bonds to maturity.

Active equity portfolio management is an attempt by the manager to outperform, on a risk

adjusted basis, a passive benchmark portfolio. A benchmark portfolio is a passive portfolio
whose average characteristics (including such factors as beta, dividend yield, industry weighting,
and firm size) match the risk-return objectives of the client. Or based on the interest rate
anticipation, valuation (intrinsic value), credit analysis
The decision whether to follow an active or passive strategy is an investor must assess the
tradeoff between the low cost but low return and the high cost but more returns.

7.1 portfolio performance evaluation

Calculating average portfolio returns does not mean the task is done. Returns must be adjusted
for risk before they can be compared meaningfully. The simplest and most popular way to adjust
returns for portfolio risk is to compare rates of return with those of other investment funds with
similar risk characteristics. Some possible risk adjusted performance measures are the following.

For now, however, we can catalog some possible risk-adjusted performance measures examine
the circumstances in which each measure might be most relevant.

1. Sharpe’s measure :(rp-rf)/ ᵟp

Sharpe’s measure divides average portfolio excess return over the sample period by the
standard deviation of returns over that period. It measures the reward to (total) volatility trade-off

2. Treynor’s measure: :(rp-rf)/ᵝp

Like Sharpe’s, Treynor’s measure gives excess return per unit of risk, but it uses systematic
risk instead of total risk.

3. Jensen’s measure (portfolio alpha):ᵟ p=rP- [rf+ᵝP(Rm-rf)]

ᵟp= excess return –Beta *market excess return

= (r-rf) –B(rm-rf)=rP- [rf+ᵝP(Rm-rf)]
Jensen’s measure is the average return on the portfolio , given the portfolio’s beta and the
average market return. Jensen’s measure is the portfolio’s alpha value.

4. Information ratio (also called appraisal ratio): ᵟP /ᵟ(eP)

The information ratio divides the alpha of the portfolio by the non-systematic risk of the
portfolio called “tracking error” in the industry. It measures abnormal return per unit of risk that
in principle could be diversified away by holding a market index portfolio.
Consider the following data for a particular sample period:
Portfolio P Market M
Average return 35% 28%
Beta 1.20 1.00
Standard deviation 42% 30%
Tracking error (nonsystematic risk), ᵟ(ᶿ) 18% 0

Calculate the following performance measures for portfolio P and the market: Sharpe, Jensen
(alpha), Treynor, information ratio. The T-bill rate during the period was 6%. By which
measures did portfolio P outperform the market? We place bars over rfas well as rPto denote the
fact that since the risk-free rate may not be constant over the measurement period, we are taking
a sample average, just as we do for rP.

Sharpe: (r- rf)/ᵟ

SP = (35 -6)/42 = .69
SM = (28 -6)/30 = .733

Alpha:rf-[ rf+ᵝ( rM-rf)]

ᵟP = 35 -[6 +1.2(28 -6)] = 2.6
ᵟM = 0

Treynor: (rp-rf)/ᵝ
TP= (35 -6)/1.2 = 24.2
TM= (28 -6)/1.0 = 22

Information ratio: ᵟ/ᵟ(e)

IP = 2.6/18 = .144
IM = 0

Jane’s portfolio P Alternative Q Benchmark M

Year’s average 2.76 7.56 1.63
Standard deviation 6.17 14.89 8.48

Excess Returns for Portfolios P and Q and the Benchmark M over a year2

Now that we have examined possible criteria for performance evaluation, we need to deal with a
statistical issue: Can we assess the quality of ex ante decisions using ex post data? Before we
plunge into a discussion of this problem, let us look at the rate of return on Jane’s portfolio over
the year. The firstTable shows the excess return recorded a year for Jane’s portfolio P,one of her
alternative portfolios Q, and the benchmark index portfolio M. The last rows inthe Table are
sample average and standard deviations. From these, and regressions of Pand Q on M, we obtain
the necessary performance statistics in the following table

PERFORMANCE STATISTICS
MEASURMENTS Portfolio P Portfolio Q Portfolio Q
Sharp’s measure 0.45 0.51 0.19
Alpha 1.63 5.28 0.00
Beta 0.69 1.40 1.00
Treynor 4.00 5.40 1.63
Tracking error (nonsystematic 1.95 8.98 0.00
risk), ᵟ(e )
Appraisal ratio 0.84 0.59 0.00

The performance statistics in the table above shows that portfolio Q is more aggressive thanP, in
the sense that its beta is significantly higher (1.40 vs. 0.69). On the other hand, from its residual
standard deviation P appears better diversified (1.95% vs. 8.98%). Both portfolios outperformed
the benchmark market index.
Which portfolio is more attractive based on reported performance? If P or Q represents the entire
investment fund, Q would be preferable on the basis of its higher Sharpe measure(0.51 vs
0 .45).On the other hand, as an active portfolio to be mixed with the market index, P is preferable
to Q, as is evident from its appraisal ratio(0.84 vs 0 .59). For the third scenario, where P and Q
are competing for a role as one of a number of sub portfolios, Q dominates again because its
Treyn or measure is higher (5.40versus 4.00). Thus, the example illustrates that the right way to
evaluate a portfolio depends in large part how the portfolio fits into the investor’s overall wealth.

7.2 INTERNATIONAL DIVERSIFICATION

International investments pose some problems not encountered in domestic markets. Among
these are the presence of exchange rate risk, on capital flows across national boundaries, an
added dimension of political risk and country-specific regulations, and differing accounting
practices in different countries.T herefore, in this chapter we review the major topics covered in
the rest of the book, emphasizing their international aspects. We start with the central concept of
portfolio theory—diversification. We will see that global diversification offers opportunities for
improving portfolio risk–return trade-offs. We also will see how exchange rate fluctuations and
political risk affect the risk of international investments.

RISK FACTORS IN INTERNATIONAL INVESTING

Opportunities in international investments do not come free of risk or of the cost of specialized
analysis. The risk factors that are unique to international investments are exchange rate risk and
country-specific risk, discussed in the next two sections

Exchange Rate Risk

Consider an investment in risk-free British government bills paying 10% annual interest in
British pounds. While these U.K. bills would be the risk-free asset to a British investor, thisis not
the case for a U.S. investor. Suppose, for example, the current exchange rate is $2 per pound, and
the U.S. investor starts with $20,000. That amount can be exchanged for£10,000 and invested at
a riskless 10% rate in the United Kingdom to provide £11,000 in1 year.
What happens if the dollar–pound exchange ratesvary over the year? Say that during the year, the
pound depreciates relative to the dollar, so that by year-end only $1.80 is required to purchase
£1. The £11,000 can be exchanged at the year-end exchange rate for only $19,800 (= £11,000
*$1.80/£), resulting in a loss of $200 relative to the initial$20,000 investment. Despite the
positive 10% pound-denominated return, the dollar denominated return is a negative 1%.
We can generalize from Example. The $20,000 is exchanged for $20,000/E0pounds, where E0
denotes the original exchange rate ($2/£). The U.K. investment grows to(20,000/E0)[1 -rf(UK)]
British pounds, where rf(UK) is the risk-free rate in the UnitedKingdom. The pound proceeds
ultimately are converted back to dollars at the subsequentexchange rate E1, for total dollar
proceeds of 20,000(E1 /E0)[1 _ rf(UK)]. The dollardenominatedreturn on the investment in
British bills, therefore, is
1 + r (US) = [1 + rf(UK)]E1 /E0
We see in Equation that the dollar-denominated return for a U.S. investor equalsthe pound-
denominated return times the exchange rate “return.” For a U.S. investor, the investment in
British bills is a combination of a safe investment in the United Kingdom anda risky investment
in the performance of the pound relative to the dollar. Here, the pound fared poorly, falling from
a value of $2.00 to only $1.80. The loss on the pound more thanoffsets the earnings on the
British bill.

Country-Specific Risk
Principle, security analysis at the macroeconomic, industry, and firmspecificlevel is similar in all
countries. Such analysis aims to provide estimates of expected returns and risk of individual
assets and portfolios. To achieve the same quality of information about assets in a foreign
country is by nature more difficult and hence more expensive. Moreover, the risk of coming by
false or misleading information isgreater.Consider two investors: an American wishing to invest
in Indonesian stocks and anIndonesian wishing to invest in U.S. stocks. While each would have
to consider macroeconomic analysis of the foreign country, the task would be much more
difficult for the American investor. The reason is not that investment in Indonesia is necessarily
riskier than investment in the U.S. You can easily find many U.S. stocks that are, in the final
analysis, riskier than a number of Indonesian stocks. The difference lies in the fact that the U.S.
investment environment is more predictable than that of Indonesia. In the past, when
international investing was novel, the added risk was referred to aspolitical risk and its
assessment was an art.

As cross-border investment has increased and more resources have been utilized, the quality of
related analysis has improved. A leading organization in the field (which is quite competitive) is
the PRS Group (Political Risk Services)and the presentation here follows the PRS methodology
PRS’s country risk analysis results in a country composite risk rating on a scale of 0(most risky)
to 100 (least risky). Countries are then ranked by composite risk measure and divided into five
categories: very low risk (100–80), low risk (79.9–70), moderate risk (69.9–60), high risk (59.9–
50), and very high risk (less than 50). To illustrate, the following Table shows the placement of
five countries in the September 2001 issue of the PRS International Country Risk Guide. The
countries shown are the two largest capitalization countries
U.S. and Japan) and the three most populous emerging markets (China, India, and
Indonesia).Surprisingly, The table shows that the U.S. ranked only 20th in September of
2001,having deteriorated from the 11th rank in the previous year. Japan actually ranked higher at
13. Both these developed countries placed in the “very low risk” category. Of the three
emergingmarkets, it is not surprising to see Indonesia ranked 115th of 140 countries, placing it in
the “high risk” category, while China ranked 60th, in the “low risk” category, and India ranked
92nd, in the “moderate risk” category.

Political Risk Variables financial risk economic risk

variables

Government stability Foreign debt (% of GDP) GDP per capita

Socioeconomic conditions foreign debt service real annual GDP growth
Investment profile (% of GDP)Annual inflation rate
Internal conflicts Current account Budget balance (% of GDP)
External conflicts (% of exports) Current account balance (% GDP)
Corruption Net liquidity in months of imports
Military in politics
Religious tensions
Exchange rate stability
Law and order
Ethnic tensions
Democratic accountability
Bureaucracy quality

Table 25.4 Composite Risk Ratings for October 2000 and September 2001

Rank, Composite Risk Composite Risk Sept. 2001

Rating Rank,
Sept. 2001 Country Rating, Sept. 2001 Rating, Oct. 2000 minus Oct.
2000 Rating Oct. 2000
Very low risk
13 Japan 86.5 83.5 3 12
20 United States 83.3 83.8 _0.5 11
Low risk
60 China 72.5 73.5 _1 47
Moderate risk
92 India 64.8 63.3 1.5 89
High risk
115 Indonesia 59.8 56.5 3.3
118

Hedging Exchange Rate Risk

Hedging;Investing in an asset to reduce the overall risk of a portfolio If the futures exchange rate
had been F0=$1.93/£ when the investment was made, theU.S. investor could have assured a
riskless dollar-denominated return by locking inthe year-end exchange rate at $1.93/£. In this
case, the riskless U.S. return would havebeen 6.15%:
[1 + rf(UK)]F0 /E0 =(1.10)1.93/2.00 =1.0615
You may recall that the futures hedge underlying Example 25.2 is the same type of hedging
strategy at the heart of the spot-futures parity relationship first discussed in Chapter22. In both
instances, futures markets are used to eliminate the risk of holding another asset. The U.S.
investor can lock in a riskless dollar-denominated return either by investing in the United
Kingdom and hedging exchange rate risk or by investing in riskless U.S. assets. Because the
returns on two riskless strategies must provide equal returns, we conclude

FO/E0=1+Rf(US)/1+Rf(uk)

This relationship is called the interest rate parity relationship or covered interest arbitrage
relationship, which we first encountered in Chapter 23.Unfortunately, such perfect exchange
rate hedging usually, is not so easy. In our example, we knew exactly how many pounds to sell
in the forward or futures market because the pound-denominated return in the United Kingdom
was riskless. If the U.K. investment had not been in bills, but instead had been in risky U.K.
equity, we would know neither the ultimate value in pounds of our U.K. investment nor how
many pounds to sell forward.

That is, the hedging opportunity offered by foreign exchange forward contracts would
beimperfect.To summarize,
1 + r (US) = [1 + r (foreign)] E1 /E0 where r (foreign) is the possibly risky return earned in the
currency of the foreign investment. You can set up a perfect hedge only in the special case that r
(foreign) is itself a known number. In that case, you know you must sell in the forward or futures
market an amount of foreign currency equal to [1 +r (foreign)] for each unit of that currency you
purchase today.

How many pounds would the investor in need to sell forward to hedge exchange rate risk if: (a)
r(UK) =20%; and (b) r(UK) = 30%?

solution
1 + r (US) = [1 + rf(UK)] *(E1/E0)
a. 1 + r (US) = 1.1 * 1.0 = 1.10. Therefore, r (US) = 10%.
b. 1 + r (US) = 1.1 *1.1 = 1.21. Therefore, r (US) = 21%.

7.3 THE PROCESS OFPORTFOLIO MANAGEMENT

The investment process is not easily reduced to a simple or mechanical algorithm. While many
principles of investments are quite general and apply to virtually all investors, some issues are
peculiar to the specific investor. For example, tax bracket, age, risk tolerance, wealth, job
prospects, and uncertainties make each investor’s circumstances somewhat unique. In this we
focus on the process by which investors systematically review their particular objectives,
constraints, and circumstances. Along the way, we survey some of the major classes of
institutional investors and examine the special issues they must confront. There is of course no
unique “correct” investment process. However, some approaches are better than others, and it
can be helpful to take one high-quality approach as a useful case study. For this reason, we will
examine the systematic approach suggested by the Association for Investment Management and
Research (AIMR). Among other things, the AIM administers examinations to certify investment
professionals as Chartered Financial Analysts. Therefore, the approach we outline is also one
that ahighly respected professional group endorses through the curriculum that it requires
investment practitioners to master. The basic framework involves dividing the investment
process into four stages: specifying objectives, specifying constraints, formulating policy, and
later monitoring and updating the portfolio as needed.

Table 26.1 Determination of Portfolio Policies

Determination of portfolio policies

Objectives ConstraintsPolicies
Return requirements Liquidity Asset allocation
Risk tolerance Horizon Diversification
Regulations Risk positioning
Taxes Tax positioning
Unique needs Income generation

Matrix objective

Type of Investor Return Requirement Risk Tolerance

Individual and Life cycle (education, Life cycle (younger are more risk
tolerant
Personal trusts children, retirement)

Mutual funds Variable Variable

Pension funds Assumed actuarial rate Depends on proximity of

payouts

Endowment funds Determined by current generally conservative

Needs and need for asset
Growth to maintain real value

Life insurance Should exceed new money rate conservative

companies by sufficient margin to meet
expenses and profit objectives;
also actuarial rates important

Non–life insurance No minimum Conservative

companies

Banks Interest spread Variable

Generally
1. When discussing the principles of portfolio management, it is useful to distinguish among
seven classes of investors:
a. Individual investors and personal trusts.
b. Mutual funds.
c. Pension funds.
d. Endowment funds.
e. Life insurance companies.
f. Non–life insurance companies.
g. Banks.
In general, these groups have somewhat different investment objectives, constraints, and
portfolio policies.
2. To some extent, most institutional investors seek to match the risk-and-return characteristics
of their investment portfolios to the characteristics of their liabilities.
3. The process of asset allocation consists of the following steps:
a. Specifying the asset classes to be included.
b. Defining capital market expectations.
c. Finding the efficient portfolio frontier.
d. Determining the optimal mix.