8

PORTFOLIo MANAGEMENT

Question 1
(a Explain briefly the two basic principles of effective portfolio management.
(10 marks) (May 1996) &(5 marks) (November 1999)
A S an investment manager you are given the following information:
Investment in equity shares of Initial Dividends Market Beta risk
price price at factor
the end of
the year

Rs. Rs Rs.
A Cement Ltd. 25 2 50 0.8
Steel Ltd. 35 2 60 0.7
Liquor Ltd. 45 2 135 0.5
E. Government of India Bonds 1,000 140 1,005 0.99
Risk free return may be taken at 14%

You are required to calculate:

0 Expected rate of returns of portfolio in each using Capitel Asset Pricing Mode! (CAPM).
(i) Average return of portfolio. (10 marks) (May 1996)
Answer Aranqement or Selechen o sectobes imtich a
(a) Portfolio manaement refers to thé selection of securities and their continuous shifting in
the portfolio to optimize returns-to suit the objectives of the investor. ma

Two Basic Principles of Portfolio management Hsk

Thertwo basic principles for effective portfolio management are:
) Effective investment planning for the investment in securities by considering the
following factors:
(a) Fiscal, financial and monetary policies of the Government of India and
Reserve Bank of India.
 8.2 Management Accounting and Financial Analysis

on industry prospects in
ndustrial and economic environment
and its impact
(6) in the market
Tems of prospective technological
changes, competition
demand prospects etc.
capacity utilisation with industry and
lioshat (Constant review of investment: Portfolio mangers
are required to review their
stantty nvestment in securities on a continuous basis to identify
more profitable avenues

icced 4

for selling and purchasing their investment. For this purpose they will have to cary
tkng it mer the following analysis:
tabe (a)Assessment of quality of management of the companies in which investment
has already been made or is proposed to be made.
(6) Financial and trend analysis of companies' balance sheets/ profits and loss
accounts to identify sound companies with optimum capital structure and better
pertormance and to disinvest the holding of those companies whose
performance is found to be slackening.
(c) The analysis of securities market and its trend is to be done on a continuous
basis.
The above analysis will help the portfolio manager to arive at a conclusion as to whether
the securities already in possession should be disinvested and new securities be
purchased. This analysis will also reveal the timing for investment or disinvestment.
(b)/() Let us first calculate the Expected retun on Market portfolio which is not given in
the question paper.

Total Investment Dividends Capital gains

Rs. Rs. Rs.
A Cement Ltd. 25 2 25
Steel Ltd. 35 2 25
Liquor Ltd. 45 2 90
B. Government of India Bonds
1.000 140 5
Total
1,105 146 145

Expected return on market portfolio=Rs40+145

1,105 =Rs.26.339%
Capital Asset Pricing Model:
E(Rp) Rf + Bp [E (RM- RI
Where,
E(Rp) Expected return of the portfolio
Rf Risk free rate of return
 Portfolio Management 8.3

Bp Portfolio beta i.e. market sensivity index

E (RM) Expected return on market portfolio.
=

E (RM-R Market risk premium.

By substituting the figures in the above equation we can calculate expected rate of
returns of portfolio in each using Capital Assets Pricing Model (CAPM) as under:
= 23.86%
Cement Ltd. 14 +0.8 (26.33 14)
Steel Ltd. =14+0.7 (26.33 - 14) 22.63%
Liquor Ltd. = 14+0.5 (26.33 14) 20.17%

Government of India Bonds 14 +0.99 (26.33 14) 26.21%

(i) Average return of the portfolio

23.86+22.63+20.17+26.2123.22%
4

OR
Average of Betas

(0.8+0.7+0.5+0.99)/4 0.7475

Average return 14 +0.7475 (26.33- 14) 23.22%

Question 2
In this context discuss the various risks
(a) "Higher the return, higher will be the risk".
associated with portfolio planning.3 Ke fer
S26, G24
(b) Following is the data regarding six securties:
A B D E

Return (%) 8 8 12 4 9 8
Risk (%) (Standard Deviation) 5 12 4 5 6
Which of the securities will be selected?

(i) Assuming perfect correlation, analyse whether it is preferable to invest 5% în secuity A and
25% in security C. (6+6 12 marks) (November, 1996)
Answer

(a) There are four different types of risks in portfolio planning.

1. Interestrate risk: It is due to changes in interest rates from time to time. Price of
the securities move invertly with change in the rate of interest.
2. Purchasing power risk: As Ainflation affects purchasing power adversely. Infiation
rates vary over time and the investors are caught unaware when the rate of inflation

IPBF
8.4
Management Accounting and Financial Analysis

changes abruptly.
3. Business risk: It arises from sale and purchase of securities affected by business
Cycles and technological changes.
4. inancial isk: This arises due to changes in the capital structure of the company.t
is expressed in terms of
debt-equity ratio Although a leveraged company's
eamings are more, too much dependence on debt financing may endanger solvency
and to some extent the liquidity.
(D) Security A has a return of 8% for a risk of 4%, whereas securities B,and F have a
nigher risk for the same rate of return. Hence security A dominates securities B and
For the same degree of risk of4% security D has only a return of 4%. Hence
this security is also dominated by A. Securities C and E have a
higher return as
well as a higher degree of risk.
Hence the securities which will be
selected are A, C and E.
i) When perfect positive correlation exist between two
securities, their risk and return
can be averaged with the Hence
proportion. the average value of A andC together
for a proportion of 3: 1 for risk and return will be as follows:
Risk (3 x 4+1x 12)/4 -6%

Return (3 x 8+1x 12)/4 9%

Comparing the above average risk and return with security E, it is better to invest in
E as it has
lesser risk (5%) for the same return of 9%.
Question 3
An investor is seeking the price to
pay for a securty, whose standard deviation is 3.00 cent.
The correlation coefficient for the
security with the market is 0.8 and the market standard per
deviation
is 2.2 per cent. The retum from
govemment
is 9.8 per cent. The investor knows that,
secunities is 5.2 per cent and from the market
portfolio
by calculating the required returm, he can then determine
the price to pay for the secunty. What is the
required retum on the security? (6 marks)
Answer
(May 1998)
Beta coefficient = Correlation coefficient between the security and the market x
Std. deviation of the
Std.deviation of the market return security retum

(8)x(05)
(022)
1.091 B x0S

Now, required retun on the security. Rate of return on risk free

return on market porfolio0 rate of retum on risk free
- security + beta coefficient (required
security)
521.091
5.2+5.02 88-52)eetp Fm Rp
10.22%
 Portfolio Management 8.5
Question 4
Write short note on
objectives of portfolio management. (5 marks) (November, 1998)
Answer
Objectives of portfolio management: Portfolio
and their continuous management refers to the selection of securities
shifting in the portfolio for optimizing the return for investor. The
the objectives of
portfolio management: following are
) Security/safety of principal: Security not only involves keeping the principal sum intact
but also keeping intact its purchasing power.
i) Stability of income: So as to facilitate
reinvestment
planning more accurately and systematically the
or
consumption of income.
(ii) Capital growth: Which can be attained by reinvesting in growth securities
purchase of growth securities. or through
(iv) Marketability: The ease with which security be
can bought or sold. This is essential to
provide flexibility to
investment portfolio.
(v)Liquidity: It is desirable foran investor to take advantage of attractive opportunities in the
market.
(vi) Diversification: The basic objective of building a
portfolio is to reduce the risk of
capitallincome by investing in various types of securities and over a wide loss ofof
industries. range
(vi) Favourable tax status: The effective yield an investor gets from his investment
on tax to which it is depends
subjected. By minimizing tax burden, yield can be improved
effectively.
Qúestion 5
Write short note on Systematic and
Unsystematic Risk in connection with Portfolio Investment.
Answer Total rok +lpsue
(5 marks) (May 1999)
Porfoio
Systematic and Unsystèmatic Risk in connection with Portfolio Investment:
Jon ver ciHable
Systematic Risk: It is the risk which cannot be eliminated Poxtf
arises because every security has built in
byldiversification.
This part of risk
The investors are
a
tendency to move in with the fluctuations in the market.
exposed to market risk even when they hold well
diversified portfolio of
securities.It is because all individual securities
move together in the same manner and therefore
Cno investors can avoid or eliminate this risk,
resorted to.
whatsoever precautions or diversification may be
The examples of systematic risk are
The government changes the interest rate policy; the
government resort to massive deficit inancing; the infation (corporate tax tate is increased;
rate increases ef
the
ushevwattc usk PxS m
 Analysis
8.6 and Financial
Management Acounting
This risk represents
diversification.
fversffalle 'sk is the risk which can
be eliminated byto particularfirm only and not to the
not
tho uc Risk: It due to factors specific diversification. It
is because
the fluctuations in returm of a security reduce this
risk through returns from these
fluctuations in
market as a whole. The investors an totally portfolio. many
random
number of securities
enter a
large
w
securities will automatically set off
each other.
The examples of unsystematic risks are expert of the Company
and Development
the Research contractin a bid etc.
declared strike in a company loses big
company: a
Workers
competitor enters
the market; the
eaves, a fomidabl
guestion 6
death:
securties on his uncle's Yield
Noe John inherited the following Nos.
Annual Maturity
Years %
Types of Security Coupon
%
3 12
10 9
Bond A (Rs. 1,000) 5 12
10 10
Bond B (Rs. 1,000) 13*
100 11
Preference shares C (Rs. 100) 100 12
13*
Preference shares D (Rs. 100)
likelihood of being called at a premium over par.
(8 marks) (May 2000)
his uncle's portfolio.
Compute the current value of
Answer
value of John's portfolio
Computation of current
9% Bonds maturity 3 years:
) 10 Nos. Bond A, Rs. 1,000 par value, Rs.
Current value of interest on
bond A
Cumulative P.V.@ 12% (1-3 years)
1-3 years: Rs. 900 x
2,162
Rs. 900x 2.402
Add: Current value of amount recelved on maturity of Bond A
End of3rd year: Rs. 1,000 x 10 x P.V.@ 12% (3rd year)
Rs. 10,000 x 0.712 Z120 9,282
10 Nos. Bond B, Rs. 1,000 par value, 10% Bonds maturity years:
5
)
bond B
Current value of interest
on
1-5years: Rs. 1,000 x Cumulative P.V. @12% (1-5 years
Rs.1,000 x3.605 3,605
amount received on maturity of Bond B
Add: Current value of
 Portfolio Managenent 8.7

End of 5th year: Rs. 1,000x 10 x P.V.@12% (5th year)

Rs. 10,000 x 0.567 5.670 9,275
(m) 100 Preference shares C, Rs. 100
par value, 11% coupon
11% x
100 Nos.xRs.100 1,100 8,462
13% 0.13
(v) 100 Preference shares D, Rs. 100 par value, 12%
coupon
12% x 100 Nos.x Rs.100 1,200
9.231 17,693
13% 0.13
Total current value of his
portfolio [(0) + (1) + (im) +() 36250
Question 7
Write short note on Factors affecting investment decisions in portfolio management.

(5 marks) (May 2000)

Answer
Factors affecting investment decisions in portfolio management:
(i) Objectives of investment portfolio: There can be
many objectives-of making an
investment. The manager of a provident fund portfolio has to
and may be satisfied with none too higher return. An
lÍok for security(low risk)
aggressive investment company
may, however, be willing to take a high risk in order to have high capital appreciation.
(i) Selection of investment:
(a) What types bf securities to buy or invest in? There is a wide variety of investments
opportunities available i.e. debentures, convertible bonds, preference shares, equity
shares, government securities and bonds, income units, capital units etc.

(b) What should be the proportion of investment in fixed interest/dividend securities and
(b)
variable interest/dividend bearing securities?

(c) In case investments are to be made in the shares or debentures of companis,

which particular industries shows potential of growth2
(d) Once industries with high growth potential have been identified, the next
select the step is to
particular companies, in whose shares or securities investments are to be
made.

(ii) Timing of purchase:

At what price the share is
acquired for the portfolio depends
entirely on the timing decision. It is obvious if a person wishes to make any gains, he
should "buy cheap and sell dear i.e. buy when the shares are
sell when they are at a high price. selling at a low price and
Question 8

A Ltd. has an expected return of 22% and Standard deviation of 40%. B Ltd. has an expected
 8.8
Management Accounting and Financial Analysis

return of 24% 0.86 and B Ltd. beta

beta of
of 1.24
Theorelationand Standard deviation of 38%. A Ltd. has a béta of a 1.24
of coefficient between the returm of A Ltd. and B Ltd. is 0.72. The Standard deviation
of the market
retum is 20%.
Suggest:
( Is investing in B Ltd. better than investing in A Ltd.?
H you invest 30% in B Ltd. and 70% in A LItd, what is your expected rate of return and
portfolio Standard deviation?
Whet is the market portfolios expected rate of retum and how much is the risk-free rate?
( What is the beta of PortfolioifA Ltad. s weight is 709% and B Ltd. 's weight is 30%?
(10 marks) (May 2002)
Answer
() A Ltd. has lower return
and higher risk than B Ltd. investing in B Ltd. is better than in A
Ltd. because the returns are
higher and the risk, lower. However, investing in both will
yield diversification advantage.
(ii) TAB .22 x 0.7 + 24x 0.3 22.6%

oAB=V.402 x0.72 +.382 x0.32+2x0.7x 0.3 x0.72 x.40x.38 .1374

= .1374=.37 37%
Answer= 37.06% is also correct and variation
may occur due to approximation.
(iii) This risk-free rate will be the same for A and B Ltd. Their rates of return
follows
are given as

TA 22 + (m-) 0.86
re 24 = r+ (m-) 1.24

TA E-2 (m-r (-0.38)

m--2/-0.38 = 5.26%

TA 22 +(5.26) 0.86
17.5% *
r24 + (5.26) 1.24
17.5%*
m-17.5 : 5.26
m 22.76%**

Answer= 17.47% might occur due to variation in

approximation.
Answer may show small variation due to
approximation. Exact answer is 22.736%.
 Portfolio Management 8.9

(v) Bas= PBA x Wa+ Ba x Ws

=
0.86 x 0.7 +1.24 x 0.3 = 0.974
Question 9
Following is the data regarding six securties:
B D E
Return (%) 8 12 8
Risk (Standard deviation) 5 12 5 6

Assuming three will have to be selected, state which ones will be picked
(i) Assuming perfect correlation, show whether it is preferable to invest 75% in A and 25% in
Corto invest 100% in E. (10 marks)(November, 2002)
Answer
(i) Security A has a return of 8% for a risk of 4, whereas B and F have a higher risk for the
same return. Hence, among them A dominates.
For the same degree of risk 4, security D has only a return of 4%. Hence, D is also
dominated by A.
Securities C and E remain in reckoning as they have a higher return though with higher
degree of risk.
Hence, the ones to be selected are A, C & E.

() The average values for Aand C for a proportion of3:1 will be

Risk X ) + ( 1 x 1 2 )

4
6%

Return (3x8)+(1x12)= g9%

.

Therefore: 75% A
25% C
Risk 5
Return 9% 9%
For the same 9% return the risk is lower in E. Hence, E will be preferable.

Question 10

Briefly explain Capital Asset Pricing Model (CAPM).

(5 marks) (November, 1997) &(6 marks) (May 2003)
 8.10
Management Accounting and Financial Analysis

Answer
Capital Asset Pricing Model:
Sharpe MAnssin Lintner
STML
ne mechanical complexity of the Marko-witz's portfolio model kept both practitioners and
ademics away from adopting the concept for practical use. lts intuitive logic, however,
Surred the creativity of a number of researchers who began examining the stock market
ucations that would arise if all investors used this model. As a result what is referred to as
the Capital Asset Pricing Model (CAPM),
developed. was
he
capital Assets Pricing Model was developed bySharpe Mossin and Lintnerin 1960. The
model explains
thetelationship between the expected return non-diversifiable risk and the
aluation of securities. It considers the required rate of return of a security on the basis of its
contribution to the total risk. It is based on the
is eliminated when more and premise that the diversifiable risk of a security
more securities are added to the portfolio.
However, the
systematic cannot diversified and is correlated with that of the market
risk be
All portfolio.
securities do not have same level of
systematic
goes with the level of systematic risk. The
risk. Therefore, the required rate of
roturn
Under CAPM, the expected return from a systematic risk can be measured
by B. beta,
security
can be expressed as:
Expected return on security =R+ Beta (Rn-R)
The model shows that the
and the risk premium. The
expected return of a security consists of the risk-free rate of interest
CAPM, when plotted on a graph paper is known as the
Market Line (SML). A
major implication of CAPM is that not only Security
portfolios too must plot on SML. This implies that in an efficient every security but all
expected to yield returns commensurate with their riskiness, measuredmarket, all securities are
The CAPM is based on byB.
following eight assumptions:
() The Investor's objective is to maximise the
utility of terminal wealth;
() Investors make choices on the basis of risk and
return;
(ii) Investors have homogenous expectations of risk
and return;
(iv) Investors have identical time horizon;
(v) Information is freely and simultaneously available
(vi) There is a risk-free asset, and investors
to investors;
can borrow and lend unlimited
risk-free rate; amounts at the
(vi) There taxes, transaction costs,
are no
imperfections; restrictions on short rates, or other market
vii) Total asset quantity is fixed, and all assets are
marketable and divisible.
CAPM can be used to estimate the expected return of
E(Rp) = Rf+ Bp [E (Rm- Ri
any portfolio with the following formula.
E(Rp) Expected return of the portfolio
Rf Risk free rate of return
 CAPm-0 Con be used au A DR
A dv. of
Useku for calcudatinq Ke for
Portfolio Management 8,J1
no diví dend (
Bp Portfolio beta i.e. market sensivity index
E (Rm)=Expected retum on market portfolio. Disad v
E (Rm)-Rf Market risk premium. Hard, to qet info" RmRe
(2 Cpnsicler only ssemahc
CAPM provides a conceptual frame work for evaluating any investment decision whercapital is
committed with a goal of producing future returns.
Question 11
An investor is holding 1,000 shares of Fatlass Company. Presently the rate of dividend being
paid bythe company is Rs. 2 per share and the share is being sold at Rs. 25 per share in
market. However, several factors are likely to change during the course of the year as
indicated below:

Existing Revised
Risk free rate 12 % 10%
Market risk premium 6% 4%
Beta value 1.4 1.25
Expected growth rate 5% 9%
In view of the above factors whether the investor should buy, hold or sell the shares? And
why? (8 marks)(May 2003)
Answer
On the basis of existing and revised factors, rate of return and price of share is to be
calculated.
Existing rate of return
Ri+Beta (Rm-R)
12% +1.4 (6%) =20.4%
Revised rate of return
10% +1.25 (4%) = 15%

Price of share (original)

1+g) 2(1.05)_2.10
P.
"K-g 204-05 2.10Rs.13.63
154
Price of share (Revised)

2(1.09)2.10-Rs.36.33
P15-09 06
In case of existing market price of Rs. 25 per share, rate of return (20.4%) and possible
equilibrium price of share at Rs. 13.63, this share needs to be sold because the share is
overpriced (Rs. 25 - 13.63) by Rs. 11.37. However, under the changed scenario where
 8.12 Management Accounting and Financial Analysis

growth of dividend has been revised at 9% and the return though decreased at 15% but the
possible price of share is to be at Rs. 36.33 and therefore, in order to expect price
appreciation to Rs. 36.33 the investor should hold the shares, if other things remain the same.
Question 12
DO
Your client is holding the following securities
Particulars of Cost Dividends Market Price BETA
Securities Rs. Rs Rs.
Equity Shares:
Co.X 8,000 800 8,200 0.8
Co. Y 10,000 800 10,500 0.7
Co. Z 16,000 800 22,000 0.5
PSU Bonds 34,000 3,400 32,300 1.0
Assuming a Risk-free rate of 15%, calculate:
Expected rate of return in each, using the Capital Asset Pricing Model (CAPM).
Average return of the portfolio.
(6 marks) (May 2003)
Answer
Calculation of expected return on market portfolio
(Rm)
Investment Cost (Rs.) Dividends (Rs.) Capital Gains
SharesX
(Rs)
8,000 800 200
Shares Y 10,000 800 500
Shares Z 16,000 800
PSU Bonds 6,000
34,000 400 1.700
68,000 5.800
R,800+5,000
5,000
68.000-x100=15.88%
68,000
Cost
Calculation of expected rate of return on individual
security
Security
Shares X 15+0.8 (15.88-15.0)
Shares Y:
15+0.7 (15.88- 15.0) 15.70%
Shares Z 15+0.5 (15.88-15.0) 15.62%
= 15.44%
PSU Bonds :
15+1.0 (15.88 15.0)
15.88%
 Portfolio Management 8.13

Calculation of the Average Return of the Portfolio:

15.70+15.62+15.44 +15.88
4

15.66%.
Question13
The rates of return on the security of Company X and market portfolio for 10 periods are given
below:
Period Return of Security Return on Market Portfolio (%)
X (%)
1 20 22
2 22 20
3 25 18
21 16
18 20
6 5 8
17
8 19 5
9 6
10 20 11
m
oY Cov (8,9)
=TXS
(9 What is the beta of SecurityX? Var c m
(10 marks)(November, 2003)
(i) What is the characteristic linefor security X?
Answer

Period Rx RM R-Rx R-Ru R, -R«)R.-Ru) -Ru

20 22 5 10 50 100

22 20 7 8 56 64
2
18 10 6 60 36
3 25
21 16 6 24 16
4
8 24 64
5 18 20
-5 8 -20 4 80 6
6
8.14 Management Accounting and Financial Analysis

17 6 18 -36 324

8 19 5 4 -7 -28 49

9 -7 6 -22 6 132 36

10 20 11 5 1 1
150 120 357 706

Rx RM (R-Rx)R-Ru) (R,-RM

Rx 15 RM 12

E(R-Rw) 706
= 78.44
o2M
n-1 9

(Rx- Rx) Ru-Ru) 357

Covx, M - 39.66
n-1 9
Covx, M 39.66
Beta .505
o M 78.44

(i) Rx 15 RM 12
Y a+Bx
15 a +0.505 x 12
Alpha (a) = 15-(0.505 x 12)

8.94%
Characteristic line for security X = a+ßx RM
where, Ru = Expected return on Market Index

.Characteristic line for security X 8.94 +0.505 RM

=

Question 14
(a) What sort of investor normally views the variance
(or Standard Deviation) of an individual
security's retun as the security's proper measure of risk?
Ihl What sort of investor rationally views the(beta bí a
s
s Eela(Suskma
measure of risk? In answering the question, explain the
security the security's
as
proper
concept of beta.
(3+ 710 marks)(May 2004)
 Answer
standard deviation) of her portfolio's
a A rational risk-averse investor views the variance (or
reason or another the investor can
return as the proper risk of her portfolio. If for some
return becomes the variance of the
hold only one security, the variance of that security's
return is the security's proper
portfolio's return. Hence, the variance of the security's
measure of risk. Rurrtttic
tAnssCtahc
non-diversifiable segments, the market
While risk is broken into diversifiable and
risk since the investor himself is expected to
generally does not reward for diversifiable
investor does not diversify he cannot be
diversify the risk himself. However, if the rewards an investor only
considered to be an efficient investor. The market, therefore,
needs to know how much non
for the non-diversifiable risk. Hence, the investor
diversifiable risk he is taking. This is measured in terms of
beta.
measure of risk,_in
An investor therefore, views the beta of a security as a proper
the non-diversifiable risk that he IS
evaluating how much the market reward him for
who is evaluating the non-diversifiable
assuming in relation to a security. An investor
viz-a-viz the market therefore
element of risk; that is, extent of deviation of returns
considerbeta às aproper measure of risk»
still views the variance (or standard
(b) If an individual holds a diversified portfolio, she
measure of the risk of her portfolio.
deviation) of her portfolios return as the proper
each individual security's return.
However, she is no longer interested in the variance of
to the variance of
Rather she is interested in the contribution of each individual security
the portfolio.
individuals hold the market
Under the assumption of homogeneous expectations, all
risk as the contribution of an individual security to the
portfolio. Thus, we measure
is the beta
variance of the market portfolio. The contribution when standardized properly
market portfolio exactly, many hold
of the security. While a very few investors hold the
close enough to the market portfolio
reasonably diversified portfolio. These portfolios are
so that the beta of a security is likely to
be a reasonable measure of its risk.
the stock with reference to a
In other words, beta of a stock measures the sensitivity of
of 1.3 for a stock would
broad based market index like BSE sensex. For example, a beta
a beta of a 0.8
indicate that this stock is 30 per cent riskier than the sensex. Similarly,
would indicate that the stock is 20 per cent (100 80) less risky than the sensex.
as the stock market
However, a beta of one would indicate that the stock is as risky
index.
Question 15
securities:
Following is the data regarding six
U W X Z
10 10 15 5 11 10
Return (%)
Risk (%) (Standard deviation) 5 6 13 5 6
 8.16 Management Accounting and Finaneial Analysis

( Which of three securities will be selected?

(i) ASSuming perfect correlation, analyse whether it is preferable to invest 80% in security u
and 20% in secunity W or to invest 100% in Y. (8 marks)(May 2004)
Answer
) When we make risk-retum analysis of different securities from U to Z, we can observe
that security U gives a return of 10% at risk level of 5%. Simultaneously securties Vand
give the same return of 10% as of security U, but their risk levels are 6% and 7%
respectively. Security X is giving only 5% return for the risk rate of 5%. Hence, security
U dominates securities V, X and Z.
Securities Wand Yoffer more return but it carries higher level of risk.
Hence securities U, Wand Ycan be selected based on indjvidual preferences.
(i) In a situation where the perfect positive correlation exists between two securities, their
risk and return can be averaged with the proportion.

Assuming the perfect corelation exists between the securities U and W, average risk and
retum of U and W together for proportion 4:1 is calculated as follows:
Risk (4 x .05+ 1x .13)+5 6.6%

Return (4 x.10+1x.15) +5 11%

When we compare risk of 6.6% and retum of 11% with seçurity Y with 6% risk and 11%
return, security Y is preferable over the porfolio of securties U and W in proportionof4:1
Question 16
Given below is information of market rates of Returns and Data from two Companies A and B:
Year 2002 Year 2003 Year 2004
Market (%) 12.0 11.0 9.0
Company A (%) 13.0 11.5 9.8
Company B (6) 11.0 10.5 9.5
Required:
(0) Determine the beta coefficients of the Shares of Company A and
Company B.
iDistinguish between Systematic risk'and 'Unsystematic risk'

(8 marks)(November, 2004)
 Portfolio Management 8.17

Answer
() Company A:
Year Retum % (Ra) Maket return Deviation Deviation DRax Rm2
%(Rm) R[a) Rm DRm
13.0 12.0 1.57 1.33 2.09 1.77
2 11.5 11.0 O.07 0.33 0.02 0.11
3 9.8 9.0 -1.63 1.67 2.72 2.79
34.3 32.0 4.83 467
Average Ra = 11.43

Average Rm = 10.67

Covariance = =242

2.42 103
2.34
Company B:
Year Return % (Ra) Market retum Deviation Deviation DRa xD Rm2
%(Rm) R(a) Rm Rm
11.0 12.0 0.67 1.33 0.89 1.77
2 10.5 11.0 0.17 0.33 0.06 0.11

9.5 9.0 -0.83 -1.67 1.39 2.79

31.0 32.0 2.34 4.67
Average Ra = 10.33
Average Rm 10.67

Covariance = -1,17

B- 0.50
2.34

(i) Systematic risk refers to the variability oft return on stocks or portfolio associated with
changes in return on the market as a whole. lt arises due to risk factors that affect the
Overall market such as changes in the nations' economy, tax reform by the Government
or a change in the world energy situation. These are risks that affect securities overall
and, consequently, the common an
cannot be diversified away. This is risk which is
entire class of assets or liabilities. The value of investments may decline over a given
to
time period simply because of economic changes or other events that impact large
8.18 Management Accounting and Financial Analysis

portions of the market. Asset allocation and diversification can protect against
systematic risk because different portions of the market tend to under perform at direrent
times. This is also called marketrisk.
or industry. It is
Unsystematic risk however, refers to risk unique to a particular company to the
due unique
avoidable through diversification. This is the risk of price change
over all market.
This risk can be
Circumstances of a specific security as opposed to the

virtually eliminated from a portfolio through diversification.

Auestion 17
 Question19
Nok
Your client is holding the following securities:
Particulars of Securties Cost Dividends/lnterest Market price Beta
Rs. Rs. Rs.
Equity Shares:
Gold Ltd. 10,000 1,725 9,800 0.6
Siliver Ltd. 15,000 1,000 16,200 0.8
Bronze Ltd. 14,000 700 20,000 0.6
GOI Bonds 36,000 3,600 34,500 1.0

Average return ofthe portfolio is 15.7%, calculate:

Expected rate of returm in each, using the Capital Asset Pricing Model (CAPM).

(ii) Risk free rate of return. (8 Marks) (November, 2005)

 Portfolio Management 8.21

Answer
Particulars of Securities Cost Rs. Dividend Capital gain
Gold Ltd. -200
10,000 1,725
Silver Ltd. 1,000 1,200
15,000
Bronz Ltd. 700 6,000
14,000
GOI Bonds 36,000 3,600 -1,500
Total 75,000 7,025 5,500
Expected rate of return on market portfolio
Dividend Eamed+Capital appreciation* 100
Initial investment
Rs.7,025+Rs.5,500 100
75,000
16.7%
Risk free return

Average of Betas=.5+0.8+0.6+1.0

Average of Betas 0.75

Average return = Risk free return + Average Betas (Expected return - Risk free return)

15.7 Risk free return +0.75 (16.7-Risk free return)

Risk free return = 12.7%

Expected Rate of Return for each security is

Rate of Return Rf+B (Rm -R)
Gold Ltd. 12.7 6 (16.7 12.7) 15.10%

Silver Ltd. 12.7+ 8 (16.7 12.7) 15.90%

Bronz Ltd. = 12.7 +.6 (16.7- 12.7) 15.10%

GOI Bonds =
12.7+1.0 (16.7 12.7) 16.70%
8.22 Management Accounting and Financial Analysis

Question 20

The distribution of return of security 'F' and the market portfolio 'P' is givenbeloW
Probability Return %
F P
0.30 30 -10
0.40 20 20
0.30 0 30
You are required to calculate the expected return of security 'F" and the market portfofio
P, the covariance between the market portfolio and security and beta for the security.
(8 Marks) (May, 2006)
Answer
Security F
Prob P) R PxR Deviations of (Deviation)2 (Deviations)
F of F
(Rr-ER)
0.3 30 9 13 169 50.7
0.4 20 8 3 9 3.6
0.3 0 0 -17 289 86.7
ER=17 Var=141
STDEV a f = V141 11.87

Market Portfolio, P
RM PM Exp. Deviation (Deviation (Deviation)2 Deviation Deviation
Ret of of PM of F) of
urn
(R P2 X x
RMX PM ERM (Dev Dev
iatio iatio
n of n of
P) P)
X

10 0.3 3 24 576 172.8 -312 -93.6

20
04 8 36 14.4 18 7.2
30 0.3 9 16 256 76.8 272 -81.6
ERM 14 Var M-264
Co Var
M=16.25 PM
168
 Portfolio Management 8.23

Co Var PM 168
Beta -.636
264
Question 21
Briefly explain the objectives of "Portfolio Management" (6 Marks) (May, 2006)
Answer
Objectives of Portfolio Management:
Portfolio management is concerned with efficient management of portfolio investment in
financial assets, including shares and debentures of companies. The management may be by
professionals or others or by individuals themselves. A portfolio of an individual or a corporate
unit is the holding of securities and investment in financial assets. These holdings are the
result of individual preferences and decisions regarding risk and return.
The investors would like to have the following objectives of portfolio management:
(a) Capital appreciation.
(b) Safety or security of an investment.
(c) Income by way of dividends and interest.

(d) Marketability.
(e) Liquidity.
() Tax Planning-Capital Gains Tax, Income tax and Wealth Tax.
(g) Risk avoidance or minimization of risk.
(h) Diversification, i.e. combining securities in a way which will reduce risk.
it is necessary that all investment proposas should be assessed in terms of income, capital
appreciation, liquidity, safety, tax inmplication, maturity and marketability i.e., saleability (i.e.,
saleability of securities in the market). The investment strategy should be based on the above
objectives after a thorough study of goals of the investor, market situation, credit policy and
economic environment affecting the financial market.
The portfolio management is a complex task. Investment matrix is one of the many
approaches which may be used in this connection. The various considerations involved in
investment decisions are liquidity, safety and yield of the investment. Image of the
organization is also to be taken into account. These considerations may be taken into account
and an overall view obtained through a matrix approach by allotting marks for each
consideration and totaling them.

Question 22
Write short notes on:

Assumptions of CAPM (6 Marks) (May, 2006)

8.24 Management Accounting and Financial Analysis

Answer
Assumptions of Capital Assets Pricing Model (CAPM)
The Capital Assets Pricing Model is based on the following eight assumptions.
(a) The Investor's objective is to maximize the utility of terminalwealth.
(b) Investor's make choices on the basis of risk and return.

(c) Investors have homogenous expectations of Risk and Return.

(d) Investors have identical time horizon.

(e) Information is freely and simultaneously available to investors.

There is risk-free asset and investors can borrow and lend unlimited amount at the risk-
( a
free rate.
short term rates or other market
(g) There no taxes, transaction costs, restrictions
are on

imperfections.
Total asset quantity is fixed and all assets are marketable and divisible.
(h)
Ouoction 23
 Question 24 tges e not egf
Discuss the various kinds of Systematic and Unsystematic risk? (6 Marks) (November, 2006)
Answer
There are two types of Risk - Systematic (ornon-diversifiable) and unsystematic (or diversifiable)
relevantfor investment- also, called as general and specific risk.
Types of SystematicRisk
() Market risk: Even if the earning power of the Corporate sector and the interest rate
structure remain more or less uncharged prices of securities, equity shares in particular,
tend to fluctuate. Major cause appears to be the changing psychology of the investors.
The irrationality in the security markets may cause losses unrelated to the basic risks.
These losses are the result of changes in the general tenor of the market and are called
market risks.
Corperale tax

Jnteres
grtatio
Conge in Govt pollcles
 Portfolio Managenment 8.27

Gi) Interest Rate Risk: The change in the interest rate have a bearing on the welfare of the
investors. As the interest rate goes (up, the market price of existing fixed income
securities falls and vice versa. This happens because the buyer of a fixed income
security would not buy it at its par value or face value if its fixed interest rate islower
than the
prevailing interest rate on a similar security.
(ii) Social or Regulatory Risk: The social or regulatory risk arises, where an otherwise
profitable investment is impaired as a result of adverse legislation, harsh regulatory
climate, or in extreme instance nationalization by a socialistic government.
(iv) Purchasing Power Risk: (Inflation or rise in prices lead to rise in costs of production,
investors
lower margins, wage rises and profit squeezing etc. The return expected by
will change due to change in real value of returns.
Classification of Unsystematic Risk
one is
) Business Risk: As a holder of corporate securities (equity shares or debentures)
to the risk of business performance. This may be caused by a variety of
exposed poor
development of
factors like heigthtened competition, emergence of new technologies,
inadequate supply of essential
Substitute_products, shifts in consumer preferences,Often of course the principal factor
and so on.
inputs, changes in governmental policies
capital stuchwe
may be inept and incompetent management.
the company, high
i) Financial Risk: This relates to the method of financing, adópted by due to
or short term liquidity problems
leverageleading to larger debt servicing problem
current assets or rise in current liabilities.
bad debts, delayed receivables and fall in
fact that a borrower may
Default Risk: Default risk refers to the risk accruing from the
(Gii) on time. Except in the case of highly risky debt
not pay interest and/or principal
to be more concerned with the perceived
risk of default rather
instrument, investors seem
Even though the actual default may be highly
than the actual occurrence of default.
believe that a change in the perceived default risk
of a bond would have an
unlikely, they
immediate impact on its market price.