CONTENTS:
1. Portfolio Analysis and Selection
2. Risk and Return Analysis
3. Beta
4. Markowitz Model
5. Capital Asset Pricing Model.
6. Arbitrage Pricing Theory
Portfolio analysis
Portfolio analysis begins where security analysis ends.
Portfolio refers to invest in a group of securities
rather to invest in a single security.
“Don’t put all your eggs in one basket”.
Portfolio analysis is the determination of the future risk and
return in holding various combinations of individual
securities.
Portfolio analysis helps to make the investment activity
more rewarding and less risky.
Portfolio Analysis
Portfolio analysis is broadly carried out for each asset at
two levels:
*Risk aversion: This method analyzes the portfolio
composition while considering the risk appetite of an
investor. Some investors may prefer to play safe and
accept low profits rather than invest in risky assets that
can generate high returns.
*Analyzing returns: While performing portfolio analysis,
prospective returns are calculated through the average and
compound return methods. An average return is simply the
arithmetic average of returns from individual assets.
However, compound return is the arithmetic mean that
considers the cumulative effect on overall returns.
The concept of diversification goes side by side with
the portfolio analysis.
Diversification aims at reduction and even elimination
of non systematic risk and achieving the specific
objective of the investors.
An investor can even estimate his expected return
and expected risk level of a given portfolio of assets
from proper diversification.
TRADITIONAL PORTFOLIO ANALYSIS
Traditional theory analyse the individual securities
under the constraint of risk and return.
This theory assumes that the selection of securities
should be on the basis of lowest risk as measured by
its standard deviation from the mean of expected
returns.
There exists a direct relationship between the
variability of returns and risk under this approach.
The greater is the variability of returns, the greater is
the risk and the vice versa.
Thus, the investor chooses assets with lowest
variability of returns.
The method of finding the return on an individual
security is by finding out
* the amounts of dividend that have been
given by the company.
* the price earnings ratio.
* the common holding period, and
* the estimation of market value of shares.
MODERN PORTFOLIO ANALYSIS
Modern Portfolio theory (MPT) a hypothesis put forth by
Harry Markowitz in his paper "Portfolio Selection,"
(published in 1952 by the Journal of Finance).
It is an investment theory based on the idea that risk-
averse investors can construct portfolios to optimize or
maximize expected return based on a given level of
market risk, emphasizing that risk is an inherent part of
higher reward.
The modern portfolio theory emphasis the need for
maximization of returns through a combination of
securities whose total variability is lower.
It is not necessary that the success could be achieved by
trying to get all securities of minimum risk.
By combining a security of low risk with another
security of high risk, success can be achieved by an
investor in making a choice of investments.
As per the modern theory, expected returns, the
variance of these returns and covariance of the
returns of the securities within the portfolio are to be
considered for the choice of the portfolio.
A portfolio is said to be efficient, if it is expected to
yield the highest return possible for the lower risk or
a given level of risk.
The return on portfolio measures the rate of return
on a portfolio measured over a period of time.
Each security in a portfolio contributes returns in the
proportion of its investment in security.
The rate of return on a portfolio can be calculated by
Weighted Average Rate of return on the various assets
within the portfolio.
This method is particularly useful for projecting into
the future the rate of return on a portfolio, given
projections of the rates of return on the constituents
of the portfolio.
It is slightly more complex but preferable.
In this the deviations are squared, making all values
positive.
Then the weighted average of these amounts is
taken, using the probabilities as weights.
The result is termed as variance.
It is converted into original units by taking the square
root. This result is termed as standard deviation.
If an investor holds only one stock, there is no
question of diversification and his risk is therefore the
standard deviation of the stock.
For a diversified investor, the risk of the stock is only
that portion of the total risk that cannot be
diversified away or its non diversifiable risk.
The non diversifiable risk is generally measured by
Beta (β) coefficient.
β measure the relative risk associated with any
individual portfolio as measured in relation to the risk
of the market portfolio
β = Non diversifiable risk of asset or portfolio
A β of 1.0 indicates an asset of average risk, a β greater
than 1.0 indicates above average risk and the β less than
1.0 indicates below average risk.
In the case of a market portfolio, all the diversification
has been done. Thus the risk of portfolio is all non
diversifiable risk which cannot be avoided.
RISK AND RETURN
Risk refers to the possibility that the actual outcome of an
investment will differ from its expected outcome.
In other words, risk is the possibility of
loss or the probable outcome of all the possible events.
Most investors are concerned about the actual outcome
being less than the expected outcome. The degree of risk
depends upon the features of assets, investment
instruments, mode of investment etc. the wider the range
of possible outcomes, the grater the risk.
RISK
SYSTEMATIC UNSYSTEMATIC
Interest Purchasing Business Financial Credit
Market Risk Rate Risk Power Risk Risk Risk Risk
The Return on an asset or investment for a given
period is the annual income received plus any change
in market price expressed as a percent of opening
market price.
Return is the primary motivating
force that drives investment. It represents the reward
for undertaking investment.
Beta (βa)
The Beta is a measure of the volatility of a stock with
respect to the market in general. The fluctuations that will
be caused in the stock due to a change in market
conditions is denoted by Beta.
Beta is common measure of risk. Beta measures the
amount of systematic risk an individual security or an
industrial sector has relative to the whole stock market.
The market has a beta of 1, and it can be used to gauge the
risk of a security. If a security's beta is equal to 1, the
security's price moves in time step with the market. A security
with a beta greater than 1 indicates that it is more volatile
than the market.
Conversely, if a security's beta is less than 1, it indicates that
the security is less volatile than the market. For example,
suppose a security's beta is 1.5. In theory, the security is 50
percent more volatile than the market.
To calculate the beta of a security,
the covariance between the return of the security and the
return of the market must be known, as well as the
variance of the market returns.
Beta =Covariance / Variance
Covariance=Measure of a stock’s return relative to that of the market
Variance=Measure of how the market moves relative to its mean
Markowitz Model
Harry M. Markowitz is credited with introducing new concepts of
risk measurement and their application to the selection of
portfolios. He started with the idea of risk aversion of average
investors and their desire to maximise the expected return with
the least risk.
Markowitz model is thus a theoretical framework for analysis of
risk and return and their inter-relationships. He used the statistical
analysis for measurement of risk and mathematical programming
for selection of assets in a portfolio in an efficient manner. His
framework led to the concept of efficient portfolios. An efficient
portfolio is expected to yield the highest return for a given level of
risk or lowest risk for a given level of return.
Markowitz generated a number of portfolios within a given
amount of money or wealth and given preferences of investors for
risk and return. Individuals vary widely in their risk tolerance and
asset preferences. Their means, expenditures and investment
requirements vary from individual to individual. Given the
preferences, the portfolio selection is not a simple choice of any
one security or securities, but a right combination of securities.
Markowitz emphasized that quality of a portfolio will be different
from the quality of individual assets within it. Thus, the combined
risk of two assets taken separately is not the same risk of two
assets together. Thus, two securities of TISCO do not have the
same risk as one security of TISCO and one of Reliance.
Risk and Reward are two aspects of investment considered
by investors. The expected return may vary depending on
the assumptions. Risk index is measured by the variance of
the distribution around the mean, its range etc., which are
in statistical terms called variance and covariance. The
qualification of risk and the need for optimisation of return
with lowest risk are the contributions of Markowitz. This
led to what is called the Modern Portfolio Theory, which
emphasizes the trade off between risk and return. If the
investor wants a higher return, he has to take higher risk.
But he prefers a high return but a low risk and hence the
problem of a trade off.
A portfolio of assets involves the selection of securities. A
combination of assets or securities is called a portfolio. Each
individual investor puts his wealth in a combination of assets
depending on his wealth, income and his preferences. The
traditional theory of portfolio postulates that selection of assets
should be based on lowest risk, as measured by its standard
deviation from the mean of expected returns. The greater the
variability of returns, the greater is the risk.
Thus, the investor chooses assets with the lowest variability of
returns. Taking the return as the appreciation in the share price, if
TELCO shares price varies from Rs. 338 to Rs. 580 (with variability
of 72%) and Colgate from Rs. 218 to Rs. 315 (with a variability of
44%) during 1998, the investor chooses the Colgate as a less risky
share.
Thus, as per the Modern Portfolio Theory, expected
returns, the variance of these returns and covariance of
the returns of the securities within the portfolio are to
be considered for the choice of a portfolio. A portfolio is
said to be efficient, if it is expected to yield the highest
return possible for the lowest risk or a given level of risk.
A set of efficient portfolios can be generated by using
the above process of combining various securities whose
combined risk is lowest for a given level of return for the
same amount of investment, that the investor is capable
of. The theory of Markowitz, as stated above is based on
a number of assumptions.
Assumptions of Markowitz Theory:
The Portfolio Theory of Markowitz is based on the following
assumptions:
(1) Investors are rational and behave in a manner as to maximise their
utility with a given level of income or money.
(2) Investors have free access to fair and correct information on the
returns and risk.
(3) The markets are efficient and absorb the information quickly and
perfectly.
(4) Investors are risk averse and try to minimise the risk and maximise
return.
(5)Investors base decisions on expected returns and variance or
standard deviation of these returns from the mean.
(6) Investors choose higher returns to lower returns for a given
level of risk.
A portfolio of assets under the above assumptions is considered
efficient if no other asset or portfolio of assets offers a higher
expected return with the same or lower risk or lower risk with
the same or higher expected return.
Capital Asset Pricing Model
History of CAPM
The CAPM is an important area of finance .WilliamSharpe, an economist
and Nobel Laureate devised CAPM for his 1970 book Portfolio
Theory and Capital Markets. He notes that an individual investment
contains two kinds of risk:
•Systematic Risk: In other words, market risk that portfolio
diversification can’t reduce. Interest rates, recessions, and wars are
examples of systematic risks.
•Unsystematic Risk: This “specific risk” relates to a specific
company or industry. Strikes, mismanagement or shortage of a
necessary component in the manufacturing process all qualify as
unsystematic risk.
CAPM exists for measuring systematic risk.
The Capital Asset Pricing Model (CAPM) is a
model that describes the relationship between
the expected return and risk of investing in a
security. It shows that the expected return on
a security is equal to the risk-free return plus
a risk premium.
CAPM Formula and Calculation
CAPM is calculated according to the following formula:
Where:
Ra = Expected return on a security
Rrf = Risk-free rate
Ba = Beta of the security
Rm = Expected return of the market
The CAPM formula is used for calculating
the expected returns of an asset. It is based
on the idea of systematic risk (otherwise
known as non-diversifiable risk) that
investors need to be compensated for in the
form of a risk premium . A risk premium is a
rate of return greater than the risk-free rate.
When investing, investors desire a higher
risk premium when taking on more risky
investments.
Risk-free return
The risk-free return is the return required by investors to
compensate them for investing in a risk-free investment. The
risk-free return compensates investors for inflation and
consumption preference, ie the fact that they are deprived from
using their funds while tied up in the investment. The return on
treasury bills is often used as a surrogate for the risk-free rate.
Risk premium
Risk simply means that the future actual return may vary from
the expected return. If an investor undertakes a risky investment
he needs to receive a return greater than the risk-free rate in
order to compensate him. The more risky the investment the
greater the compensation required. This is not surprising and it
is what we would expect from risk- averse investors.
CAPM as an Important tool
The capital asset pricing model is important in the
world of financial modeling for a few key reasons.
Firstly, by helping investors calculate the expected
return on an investment, it helps determine how
appropriate a particular investment may be.
Investors can use the CAPM for gauging their
portfolio’s health and rebalancing, if necessary.
Secondly, it’s a relatively simple formula that’s
fairly easy to use. Additionally, the CAPM is an
important tool for investors when it comes to
accessing both risk and reward. It’s also one of the
few formulas that accounts for systematic risk.
Assumptions
The CAPM is often criticised as unrealistic because of the
assumptions on which the model is based, so it is important
to be aware of these assumptions and the reasons why they
are criticised. The assumptions are as follows
• Investors hold diversified portfolios
This assumption means that investors will only require a
return for the systematic risk of their portfolios, since
unsystematic risk has been diversified and can be ignored.
• Single-period transaction horizon
A standardised holding period is assumed by the CAPM to
make the returns on different securities comparable. A return
over six months, for example, cannot be compared to a return
over 12 months. A holding period of one year is usually used.
• Investors can borrow and lend at the risk-free rate of
return
This is an assumption made by portfolio theory, from which the
CAPM was developed, and provides a minimum level of return
required by investors.
• Perfect capital market
This assumption means that all securities are valued
correctly and that their returns will plot on to the SML. A
perfect capital market requires the following: that there
are no taxes or transaction costs; that perfect information
is freely available to all investors who, as a result, have
the same expectations; that all investors are risk averse,
rational and desire to maximise their own utility; and that
there are a large number of buyers and sellers in the
market.
The assumption that investors hold diversified portfolios
means that all investors want to hold a portfolio that reflects
the stock market as a whole. Although it is not possible to
own the market portfolio itself, it is quite easy and
inexpensive for investors to diversify away specific or
unsystematic risk and to construct portfolios that ‘track’ the
stock market. Assuming that investors are concerned only
with receiving financial compensation for systematic risk
seems therefore to be quite reasonable.
Overall, it seems reasonable to conclude that while the
assumptions of the CAPM represent an idealised world rather
than the real-world, there is a strong possibility, in the real
world, of a linear relationship between required return and
systematic risk.
SECURITY MARKET LINE
The security market line (SML) is a line drawn on a chart
that serves as a graphical representation of the CAPM—
which shows different levels of systematic, or market risk,
of various marketable securities, plotted against
the expected return of the entire market at any given time.
Also known as the "characteristic line," the SML is a
visualization of the CAPM, where the x-axis of the chart
represents risk (in terms of beta), and the y-axis of the
chart represents expected return. The market risk
premium of a given security is determined by where it is
plotted on the chart relative to the SML.
The security market line is an investment evaluation tool
derived from the CAPM—a model that describes risk-
return relationship for securities—and is based on the
assumption that investors need to be compensated for
both the time value of money (TVM) and the
corresponding level of risk associated with any
investment, referred to as the risk premium.
The concept of beta is central to the CAPM and the
SML. The beta of a security is a measure of its
systematic risk , which cannot be eliminated by
diversification. A beta value of one is considered as the
overall market average. A beta value that's greater than
one represents a risk level greater than the market
average, and a beta value of less than one represents a
risk level that is less than the market average.
The formula for plotting the SML is:
•Required return = risk-free rate of return + beta
(market return - risk-free rate of return)
CAPM, SML, and Valuations
Together, the SML and CAPM formulas are useful in
determining if a security being considered for
investment offers a reasonable expected return for
the amount of risk taken on. If a security’s expected
return versus its beta is plotted above the security
market line, it is considered undervalued, given the
risk-return tradeoff. Conversely, if a security’s
expected return versus its systematic risk is plotted
below the SML, it is overvalued because the investor
would accept a smaller return for the amount of
systematic risk associated.
The SML can be used to compare two
similar investment securities that have approximately
the same return to determine which of the two
securities carries the least amount of inherent risk
relative to the expected return. It can also compare
securities with equal risk to determine if one offers a
higher expected return.
The CAPM and the Efficient Frontier
The capital market line (CML) represents portfolios that
optimally combine risk and return. CAPM, depicts the
trade-off between risk and return for efficient portfolios. It
is a theoretical concept that represents all the portfolios
that optimally combine the risk-free rate of return and the
market portfolio of risky assets.
Using the CAPM to build a portfolio is
supposed to help an investor manage their
risk. If an investor were able to use the CAPM
to perfectly optimize a portfolio’s return relative
to risk, it would exist on a curve called the
efficient frontier, as shown on the following
graph.
The efficient frontier is the set of optimal portfolios
that offer the highest expected return for a defined
level of risk or the lowest risk for a given level of
expected return. Portfolios that lie below the efficient
frontier are sub-optimal because they do not provide
enough return for the level of risk. Portfolios that
cluster to the right of the efficient frontier are sub-
optimal because they have a higher level of risk for
the defined rate of return.
The graph shows how greater expected returns (y-axis)
require greater expected risk (x-axis). Modern Portfolio
Theory suggests that starting with the risk-free rate, the
expected return of a portfolio increases as the risk
increases. Any portfolio that fits on the Capital Market Line is
better than any possible portfolio to the right of that line, but
at some point, a theoretical portfolio can be constructed on
the CML with the best return for the amount of risk being
taken.
The CAPM, is the line that connects the risk-free rate
of return with the tangency point on the efficient frontier
of optimal portfolios that offer the highest expected
return for a defined level of risk, or the lowest risk for a
given level of expected return. The portfolios with the
best trade-off between expected returns and variance
(risk) lie on this line. The tangency point is the optimal
portfolio of risky assets, known as the market portfolio.
Under the assumptions of mean-variance analysis –
that investors seek to maximize their expected return
for a given amount of variance risk, and that there is a
risk-free rate of return – all investors will select
portfolios which lie on the CML.
The Capital Market Line and the Security
Market Line
The CML is sometimes confused with the security market (SML).
The SML is derived from the CML. While the CML shows the rates
of return for a specific portfolio, the SML represents the market’s
risk and return at a given time, and shows the expected returns of
individual assets. And while the measure of risk in the CML is the
standard deviation of returns (total risk), the risk measure in the
SML is systematic risk, or beta. Securities that are fairly priced will
plot on the CML and the SML. Securities that plot above the CML
or the SML are generating returns that are too high for the given
risk and are under-priced. Securities that plot below CML or the
SML are generating returns that are too low for the given risk and
are overpriced.
Calculation of beta is a tedious and time consuming process as it requires
ample amount of information. Again beta may or may not reflect the
future variability of returns and it cannot be expected to be same all the
time. It will change with time and situation.
The specified required rate of return can be considered as only
approximation.
Perfect capital market exists i.e, the market is efficient market.
Lending and borrowing can take place at risk free rates.
All investors have the same expectations about return and risk.
Risk is measured on the basis of historic returns patterns and assumption
is that returns pattern will repeat in the future.
It also assumes that in the financial markets there are no transaction costs,
no taxes and no limitations on investments.
The CAPM also assumes that investors are fully diversified. In practice
many investors, particularly small investors, do not hold highly
diversified asset portfolio.
The Arbitrage Pricing Theory (APT)
The Arbitrage Pricing Theory (APT)
It is a theory of asset pricing that holds that an
asset’s returns can be forecasted with the linear
relationship of an asset’s expected returns and
the macroeconomic factors that affect the asset’s risk. The
theory was created in 1976 by American economist,
Stephen Ross. The APT offers analysts and investors a
multi-factor pricing model for securities, based on the
relationship between a financial asset’s expected return
and its risks.
The APT aims to pinpoint the fair market price of a security that may be
temporarily incorrectly priced. It assumes that market action is less than
always perfectly efficient, and therefore occasionally results in assets
being mispriced – either overvalued or undervalued – for a brief period of
time.
However, market action should eventually correct the situation, moving
price back to its fair market value. To an arbitrageur, temporarily
mispriced securities represent a short-term opportunity to profit virtually
risk-free.
The APT is a more flexible and complex alternative to the Capital Asset
Pricing Model (CAPM). The theory provides investors and analysts with
the opportunity to customize their research. However, it is more difficult
to apply, as it takes a considerable amount of time to determine all the
various factors that may influence the price of an asset.
Assumptions in the Arbitrage Pricing Theory
The Arbitrage Pricing Theory operates with a
pricing model that factors in many sources of
risk and uncertainty. Unlike the Capital Asset
Pricing Model (CAPM), which only takes into
account the single factor of the risk level of
the overall market, the APT model looks at
several macroeconomic factors that, according
to the theory, determine the risk and return of
the specific asset.
These factors provide risk premiums for investors to
consider because the factors carry systematic risk that
cannot be eliminated by diversifying.
The APT suggests that investors will diversify their
portfolios, but that they will also choose their own
individual profile of risk and returns based on the
premiums and sensitivity of the macroeconomic risk
factors. Risk-taking investors will exploit the differences
in expected and real returns on the asset by using
arbitrage.
Arbitrage in the APT
The APT suggests that the returns on assets follow a linear pattern. An
investor can leverage deviations in returns from the linear pattern using
the arbitrage strategy. Arbitrage is the practice of the simultaneous
purchase and sale of an asset on different exchanges, taking advantage of
slight pricing discrepancies to lock in a risk-free profit for the trade.
However, the APT’s concept of arbitrage is different from the classic
meaning of the term. In the APT, arbitrage is not a risk-free operation –
but it does offer a high probability of success. What the arbitrage pricing
theory offers traders is a model for determining the theoretical fair
market value of an asset. Having determined that value, traders then look
for slight deviations from the fair market price, and trade accordingly
For example, if the fair market value of stock A is
determined, using the APT pricing model, to be $13,
but the market price briefly drops to $11, then a
trader would buy the stock, based on the belief that
further market price action will quickly “correct” the
market price back to the $13 a share level.
Mathematical Model of the APT
The Arbitrage Pricing Theory can be expressed as a
mathematical model:
Where:
•ER(x) – Expected return on asset
•Rf – Riskless rate of return
•βn (Beta) – The asset’s price sensitivity to factor
•RPn – The risk premium associated with factor
