UNIT- V

CAPITAL ASSET PRICING MODEL

The Capital Asset Pricing Model (CAPM) is a financial model that calculates an asset's expected return
based on its risk. CAPM helps investors determine if an investment's expected return justifies its systematic
risk and is used in investment valuation and portfolio management.
It uses the formula:
Expected Return = Risk-Free Rate + β × (Market Return - Risk-Free Rate),
Where, β (beta) measures the asset's volatility relative to the overall market.
Components of the CAPM Formula
 Risk-Free Rate (Rf): The theoretical rate of return on an investment with zero risk, often represented by
government bonds.
 Beta (β): A measure of an asset's volatility or risk compared to the overall market.
 A beta of 1 indicates the asset moves in line with the market.
 A beta greater than 1 suggests higher volatility than the market.
 A beta less than 1 indicates lower volatility.
 Market Return (Rm): The expected return of the overall market, which serves as a benchmark for
comparison.
 Market Risk Premium (Rm - Rf): The additional return investors expect for taking on market risk
compared to a risk-free asset.

Importance of CAPM in finance

CAPM is an important concept in finance and investment matters. It helps investors gain a clear idea
about a security’s ability to offer returns to the investor. It also evaluates the risks and the investment’s
sensitivity to market changes. Therefore, the CAPM plays a crucial role in determining risk-free assets and
boosting investment decision-making.

LENDING AND BORROWING

CAPM posits that the expected return on any investment should equal the risk-free rate plus a risk
premium. This premium accounts for the asset's market risk, or systematic risk (the risk of the market as a
whole). Investments with higher beta (higher systematic risk) should offer higher expected returns to
compensate investors for that risk.
Assumptions of CAPM
The following are the assumptions of the CAPM model.
1. Market efficiency: The first and foremost important assumption of the Capital Asset Pricing Model is its
belief that markets are efficient. According to CAPM, the investment market is highly efficient. This means
the market price of different securities reflects all essential information about the stock or security.
2. Investors’ rationality: Investors’ rationality is also one of the popular assumptions of the CAPM model.
According to the Capital Asset Pricing Model, investors can reasonably or rationally accept or decline risky
investments. It claims that investors have the freedom to choose risk-averse assets by simply taking
systematic risks and diversifying unsystematic risks in investment.
3. Single-period transaction: According to the Capital Asset Pricing Model, it holds a standard investment
holding period to make every invested asset compatible. For example, as per CAPM, an investment return
of 6 months cannot be compared with the 3-month holding returns. Generally, CAPM holds 1 year as a
standardized holding period for any classes of asset.
4. Homogeneous expectations: The assumptions of the CAPM model, including homogeneous expectations,
are very crucial. This assumption says that there is a linear relationship between the return on an asset and
its diversified risks can lead to a significant change in the market dynamics. Not only that, but it also
consequently, impacts asset price determination and marks it as high-risk.
5. No taxes or transaction costs: No tax or transaction cost is also one of the primary assumptions of the
CAPM model. According to the portfolio theory CAPM the risk-free return corresponds to the SML or
intersection of the Security Market Line and the y-axis line. The SML is basically a graphical
representation of the CAPM.
6. Risk-free borrowing and lending: Lastly, the CAPM model includes risk-free lending and borrowing.
The CAPM model assumes that the lending is a risk-free investment as the investors have to pay interest on
borrowed funds. Therefore, borrowing is also assumed to have the same risk-free interest rates as a result
 they are also deemed as risk-free borrowing.
Practical Applications
 Stock valuation: CAPM can be used for stock valuation. Both companies who are issuing stocks for
trading and investors looking for suitable investment options use this CAPM model to evaluate the
value of stocks listed on the index. The investors use the CAPM model to estimate the returns the
security can offer, leading to an overall stock valuation before investing in it.
 Portfolio management: The CAPM model is also used for portfolio management. CAPM helps to
assess the risk and return relationship of an asset and how much return the asset can bring back to the
investor. Therefore, the model works as an excellent tool to assess different stocks and security in
relation to their sensitivity to market changes to offer appropriate guidance for portfolio diversification
or management.
 Capital budgeting: Last but not least, the CAPM model is also used for capital budgeting purposes. To
be more specific CAPM is used to evaluate the expected returns given the capital costs and assets risk.
Applying this model for capital budgeting requires the rate of return for the general market, the beta
value of securities, and the risk-free rate.

Uses of CAPM
1. The CAPM focuses on the market risk, makes the investors to think about the riskiness of the assets.
2. The CAPM has been useful in the selection of securities and portfolios.
3. Given the estimate of the risk free rate, the beta of the firm, stock and the required market rate of return,
one can find out the expected returns for a firm’s security.
Limitations of CAPM
While useful, the CAPM is based on several simplifying assumptions, such as perfect markets and
homogeneous expectations, which may not hold true in the real world. These assumptions can limit the model's
accuracy, and some alternative models and factors have been developed to address market anomalies and
additional sources of risk.

CML - CAPITAL MARKET LINE

The Capital Market Line is a graphical
representation of all the portfolios that optimally
combine risk and return. CML is a theoretical concept
that gives optimal combinations of a risk-free asset and
the market portfolio. The CML is superior to Efficient
Frontier because it combines risky assets with risk-free
assets.
The Capital Market Line (CML) is a theoretical
concept in finance that represents the most efficient
portfolios, which optimally combine a risk-free asset
with a diversified market portfolio. It graphically
illustrates the relationship between risk (standard
deviation) and expected return, showing that portfolios
higher on the line offer higher expected returns for
increased risk.

Formula for the CML

The CML's formula is: *ERp = Rf + SDp and (ERm – Rf) / SDm.
Where:
 ERp: is the expected return of the portfolio.
 Rf: is the risk-free rate.
 SDp: is the standard deviation of the portfolio.
 ERm: is the expected return from the market.
 SDm: is the standard deviation of the market.

Components of the CML

 Risk-Free Asset: A theoretical investment (like government bonds) with zero risk.
  Risk-Free Rate (Rf): The return from the risk-free asset.
 Market Portfolio (M): A theoretical portfolio containing all risky assets in the market.
 Expected Return of the Market (ERm): The anticipated return of the market portfolio.
 Standard Deviation of the Market (SDm): The risk (volatility) of the market portfolio.
 Standard Deviation of the Portfolio (SDp): The risk of a specific portfolio being considered.

Construction and Understanding of CML

1. Plot the Risk-Free Asset: This is your starting point on the graph, located at the risk-free rate on the y-
axis and zero risk on the x-axis.
2. Locate the Market Portfolio: Find the point on the Efficient Frontier (the curve of optimal risky
portfolios) that gives the highest Sharpe ratio, or reward-to-variability ratio. This is the market portfolio.
3. Draw the Tangent Line: Draw a straight line from the risk-free asset through the market portfolio. This is
the CML.
Interpretation of CML:
 Moving Up: Portfolios on the CML above the market portfolio involve borrowing at the risk-free rate to
invest more in the market portfolio, increasing both risk and expected return.
 Moving Down: Portfolios on the CML below the market portfolio involve investing in both the risk-free
asset and the market portfolio, resulting in lower risk and lower expected returns.

SML – SECURITY MARKET LINE

 The Security Market Line (SML) is a graphical or visual representation of the capital asset pricing
model (CAPM). It shows the relationship between an investment's expected return and its systematic
risk, measured by beta.
 The line's Y-axis shows expected returns, and the X-axis shows beta. The SML is an upward slope. It
shows the expected return of securities for different levels of risk.
 The assets that appear above the SML are considered overvalued. It suggests that the expected returns
of the assets are higher than the justified required returns.
 The assets that lie below the SML are undervalued. It suggests that the expected returns of the assets
are lower than the justified required returns.

Components of the SML

The security market line is made up of the risk-free
rate, the beta of the asset related to the market, and the
expected market risk premium. The components will yield
the expected return of an asset. Additionally, the SML
formula can be used to calculate the asset’s risk premium.
Below is the formula to calculate the security market line:
Security Market Line = Risk-Free Rate + [Beta *
(Expected Market Return – Risk-Free Rate)]
Where:
 Risk-Free Rate – Current risk-free rate
 Beta – Beta of the security to the market
 Expected Market Return – Expected return of all
risky assets
Plotting the function for all positive betas, with the constraint of a positive market risk premium (Expected
Market Return – Risk-Free Rate), will give the typical security market line. To get the expected risk premium
of a security, subtract the first risk-free rate from both sides of the equation. It will produce:
Expected Security Risk Premium = Beta * (Expected Market Return – Risk-Free Rate)

Interpretation of SML
 On the Line: If an asset's expected return and beta plot directly on the SML, it is considered fairly priced.
 Above the Line: If an asset plots above the SML, it is undervalued, meaning it offers a higher return for its
level of risk, making it attractive.
 Below the Line: If an asset plots below the SML, it is overvalued, as it provides a lower return for its risk.
Purpose and Use
 Risk-Return Assessment: The SML helps investors understand the relationship between risk and
expected return, ensuring they are adequately compensated for the systematic risk they take.
 Investment Evaluation: Investors use the SML to assess whether a security is underpriced or
overpriced relative to its risk, informing decisions on whether to buy or sell.
 Pricing Insights: It provides insights into how market dynamics and economic conditions can affect
investment returns and security pricing.

Assumptions of the Security Market Line

The following are some of the assumptions of SML:
 There is no possibility of any short-selling.
 Every investor follows the same investment timeline.
 There are several high-risk securities.
 Everybody in the market acts reasonably.
 All market participants are price takers. They cannot affect the price of the assets.
 There are no fees or taxes associated with these transactions.

PRICING WITH CAPM

Pricing using the Capital Asset Pricing Model (CAPM) involves using a formula to calculate the
expected return on an investment based on its systematic risk. The formula is E(Rᵢ) = Rƒ + βᵢ (E(Rₘ) - Rƒ),
where E(Rᵢ) is the expected return of the asset, Rƒ is the risk-free rate, βᵢ is the asset's beta (its volatility
relative to the market), and (E(Rₘ) - Rƒ) is the market risk premium.

Practice of Pricing with CAPM

1. Identify the inputs:
 Risk-Free Rate (Rƒ): This is the theoretical rate of return on an investment with zero risk, often
represented by the yield on government bonds.
 Beta (βᵢ): This measures the asset's volatility in comparison to the overall market. A beta of 1.0 means
the asset's price moves with the market, while a beta greater than 1.0 indicates it's more volatile, and a
beta less than 1.0 indicates it's less volatile.
 Expected Market Return (E (Rₘ)): This is the anticipated return of the overall market, typically a
broad stock market index.
 Market Risk Premium: This is the excess return investors expect for investing in the stock market
over the risk-free rate (E (Rₘ) - Rƒ).
2. Apply the Formula:
 E(Rᵢ) = Rƒ + βᵢ (E(Rₘ) - Rƒ)
 For example, if the risk-free rate is 2%, the beta of a stock is 1.25, and the expected market
return is 8%, the market risk premium is 6% (8% - 2%). The expected return would be: 2% +
(1.25 * 6%) = 2% + 7.5% = 9.5%.
Benefits
 The CAPM formula helps determine the required rate of return or cost of equity for an investment,
which can then be used in other financial decisions, such as project evaluation or valuation.
 It provides a framework for understanding the relationship between systematic risk (market-wide risks
like inflation or recession) and expected returns.
 By quantifying risk, CAPM helps investors assess if an investment's potential return adequately
compensates for its risk, allowing for more informed investment decisions.

ARBITRAGE PRICING THEORY

Arbitrage Pricing Theory (APT) is a financial model developed by Stephen Ross in 1976 that explains
asset returns using multiple macroeconomic factors and their sensitivities. It posits that an asset's expected
return is driven by its exposure to various systematic risk factors, like inflation or GDP growth, and that no-
arbitrage opportunities will be exploited in efficient markets, ensuring assets are fairly priced based on these
factors. The
Meaning
 The Arbitrage Pricing Theory (APT) 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 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.
Principles of APT
 Multiple Risk Factors: Unlike CAPM's single-factor model, APT uses several common
macroeconomic variables as risk factors.
 No Arbitrage Assumption: APT assumes that in an efficient market, any asset mispricing (an
arbitrage opportunity) will be quickly corrected, making it impossible to profit risk-free from temporary
price discrepancies.
 Factor Sensitivity: The model emphasizes an asset's sensitivity (beta, or B) to each risk factor, with a
higher sensitivity indicating a greater impact of that factor on the asset's return.
 Factor Risk Premium: Each identified risk factor is associated with a risk premium (RP or λ) that
compensates investors for bearing that specific systematic risk.
Formula
The core of the APT is a linear model to predict an asset's expected return.
E (rj) = rf + βj1RP1 + βj2RP2 + ... + βjnRPn
Where:
 E (rj) = The asset's expected rate of return.
 rf = The risk-free rate of return.
 βj = The sensitivity (beta) of the asset's return to the specific factor.
 RP = the risk premium associated with that factor.

Examples of Factors
Common factors used in APT models can include: Inflation, Interest rates, Gross Domestic Product
(GDP) growth, Market volatility, and Exchange rates.

Advantages and Applications

 Flexibility: APT is more flexible than CAPM, allowing for the inclusion of multiple risk factors that
may better explain asset returns.
 Broader Factors: It incorporates various macroeconomic variables, providing a more comprehensive
view of risk compared to CAPM's single-factor approach.
 Market Inefficiency Insight: The theory suggests that occasional market inefficiencies can create
temporary arbitrage opportunities, which can be exploited for profit.

PORTFOLIO EVALUATION
Portfolio evaluation is an essential aspect of investment analysis. It involves assessing the quality of
investment approaches and determining changes to improve investment results.
A portfolio combines investment products, including bonds, shares, securities, and mutual funds. Experienced
portfolio managers customize this combination based on the client’s risk tolerance to create a long-term return
portfolio.
Performance evaluation is necessary for both investors and portfolio managers. Portfolio management
uses evaluation to assess the manager’s portfolio performance and determine their compensation.
Investors can assess portfolio performance by comparing it to a relevant benchmark within the specified
category and determine whether it has outperformed, underperformed, or performed comparably. A well-
balanced portfolio minimizes risks, grows in value, shields investors from loss, and improves liquidity.
Protect your investments and secure your financial future. Our expert portfolio analysis services provide the
insights you need to make informed decisions.

Meaning
Portfolio evaluation is the process of assessing an investment portfolio's performance over a specific
period to determine if it met its financial goals and objectives. This evaluation involves measuring returns,
analyzing the associated risks, and comparing performance against a relevant benchmark or industry
standard. The insights gained from a portfolio evaluation help investors and managers understand what
worked, what didn't, and what adjustments are needed to improve future performance.
Importance of Portfolio Evaluation
 Performance Measurement: This involves calculating the actual returns generated by the portfolio
over a given investment period.
 Risk Analysis: Evaluating the risk taken to achieve those returns is crucial, as investors aim to
maximize returns while minimizing risk.
 Benchmark Comparison: The portfolio's performance is often compared to a relevant market index or
a benchmark portfolio to see if it has outperformed, underperformed, or performed comparably to the
market.
 Goal Alignment: The evaluation checks if the portfolio is meeting the investor's specific financial
objectives and staying within their risk tolerance.
 Identifying Areas for Improvement: By understanding what led to successes or failures, investors can
make informed decisions about adjusting their portfolio's composition for future success.
 Completes the Portfolio Management Cycle: It is the final step in the portfolio management process,
providing feedback for future strategies.
 Informs Decision-Making: It provides investors with the data needed to understand their current
position and to make strategic adjustments to their holdings.
 Manager Accountability: It holds portfolio managers accountable for their performance and helps in
determining their compensation.

Methods of Portfolio Evaluation

When evaluating your portfolio, it’s crucial to consider both the returns you’re earning and the risks
you’re taking to achieve them. High returns alone may not justify taking on high levels of risk. Here, we have
discussed some of the most commonly used methods that comprehensively understand your portfolio’s
performance.

Traditional Method
The traditional method is pretty straightforward as it focuses on measuring the returns generated by the
portfolio compared to a standardized reference point. However, the traditional portfolio evaluation method
does not consider the risks taken. To address this limitation, risk-adjusted techniques have been developed to
evaluate portfolio performance.

1. SHARPE'S INDEX
In 1966, William F. Sharpe developed the Sharpe ratio as a tool to evaluate the risk-adjusted return that
considers both the standard deviation of the portfolio’s returns and the risk involved in achieving that return.
Sharpe ratio = (RP – RF) / σP
Where,
RP – Portfolio Return
RF – Risk-free rate of return
σP – Standard deviation of the portfolio’s returns
A higher Sharpe ratio reflects a higher risk-adjusted return.
A well-diversified portfolio will have a lower standard deviation and a higher Sharpe ratio than a concentrated
portfolio with the same return. It also assumes that investors are risk-averse and prefer lower risk and higher
return.

2. TREYNOR'S INDEX
The Treynor measure, first introduced by Jack L. Treynor, is a performance metric that assesses the
risk-adjusted return of an investment portfolio by evaluating the portfolio’s return per unit of systematic and
assumes that the portfolio has already eliminated unsystematic risk.
Treynor’s measure = (RP – RF) / ß
Where,
RP – Portfolio Return
RF – Risk-free rate of return
ß – Beta coefficient
A higher measure indicates better portfolio performance.
3. JENSEN'S INDEX
Based on the Capital Asset Pricing Model (CAPM), the Jensen measure measures how much return a
portfolio generates above the expected return from the market. The excess return generated by the portfolio is
also known as alpha.
Jensen’s α = RP – [RF + (ß) * (RM – RF)]
Where,
RP – Portfolio Return
RF – Risk-free rate of return
RM – Market rate of return
ß – Beta coefficient
A consistently positive alpha indicates that the portfolio is performing above average, while a negative
alpha signals that the portfolio is underperforming. The measure calculates risk premiums in beta, representing
systematic risk. Therefore, this ratio is best applied to an investment that is already adequately diversified.

Strategies to Evaluate Portfolio

When evaluating portfolio, there are several tips to keep in mind.
1. Assessing how you have allocated traditional assets in your portfolio is essential.
2. High-risk investments provide high returns, and it is important to keep a check on the volatile rates and
invest where you can profit the most.
3. It is important to remember that expensive investment products can deplete a portfolio over time.
4. Comparing how your fund or stock behaves relative to others in the same industry or sector can help
you make informed decisions about your portfolio.
5. Regularly making the necessary updates and tweaks to your portfolio is important.
By following these tips, you can effectively evaluate your portfolio and make informed investment decisions.

MUTUAL FUNDS
A mutual fund is an SEC-registered open-end investment company that pools money from many
investors. It invests the money in stocks, bonds, short-term money-market instruments, other securities or
assets, or some combination of these investments. The combined holdings the mutual fund owns are known as
its portfolio, which is managed by an SEC-registered investment adviser. Each mutual fund share represents an
investor’s part ownership of the mutual fund’s portfolio and the gains and losses the portfolio generates.
Investors in mutual funds buy their shares from, and sell/redeem their shares to, the mutual funds themselves
or through investment professionals like brokers or investment advisers.

Features of Mutual funds

Mutual funds are a popular choice among investors because they generally offer the following features:
 Professional Management: Mutual funds are managed by investment advisers who are registered with
the SEC.
 Diversification: Mutual funds may invest in a range of companies and industries rather than investing
in one specific stock or bond. This helps to lower your risk if one company fails.
 Low Minimum Investment: Many mutual funds set a relatively low dollar amount for initial
investment and subsequent purchases.
 Liquidity. Mutual fund investors can readily sell their shares back to the fund at the next calculated net
asset value (NAV) – on any business day – minus any redemption fees.

Ways to earn benefits from mutual funds

Investors can make money from their mutual fund investments in three ways:
 Dividend Payments. A fund may earn income from its portfolio – for example, dividends on stock or
interest on bonds. The fund then pays the shareholders nearly all the income, less expenses, as a dividend
payment.
 Capital Gains Distributions. The price of the securities a fund owns may increase. When a fund sells a
security that has increased in price, the fund has a capital gain. At the end of the year, the fund distributes
these capital gains, minus any capital losses, to investors.
 Increased Net Asset Value (NAV). If the market value of a fund’s portfolio increases, after deducting
 expenses and liabilities, then the NAV of the fund and its shares increases. With respect to dividend
payments and capital gains distributions, mutual funds usually will give investors a choice. The mutual
fund can transfer the amount to the investor, or the investor can have the dividends or distributions
reinvested in the mutual fund to buy more shares.

What are the risks of investing in mutual funds?

 Mutual funds are not guaranteed or insured by the FDIC or any other government agency. They
therefore all carry some level of risk. You may lose some or all of the money you invest because the
investments held by a fund can go down in value. Dividends or interest payments may also change as
market conditions change.
 A fund’s past performance is not as important as you might think because past performance does not
predict future returns. But past performance can tell you how volatile or stable a fund has been over a
period of time. The more volatile the fund, the higher the investment risk.
 Different funds have different risks and rewards depending on their investment objectives. Generally,
the higher the potential return, the higher the risk of loss.

Costs involved in mutual fund

 As with any business, running a mutual fund involves costs. Funds pass along these costs to investors
by deducting fees and expenses from NAV. That means you pay the fees and expenses indirectly.
 Fees vary from fund to fund. It is important to understand what fees a mutual fund charges and how
those fees impact your investment. Even small differences in fees can mean large differences in returns
over time. In addition, a fund with high costs must perform better than a low-cost fund to generate the
same returns for you.

What are some common mutual fund investing strategies?

 Index Funds. Index funds follow a passive investment strategy that is designed to achieve
approximately the same return as a particular index before fees. An index fund will attempt to achieve
its investment objective primarily by investing in the securities of companies that are included in a
selected index. Passive management usually translates into less trading of the fund’s portfolio (fewer
transaction costs), more favorable income tax consequences (lower realized capital gains), and lower
fees than actively managed funds.
 Actively Managed Funds. Actively managed funds are not based on an index. Instead, they seek to
achieve a stated investment objective by investing in a portfolio of stocks, bonds, and other assets. An
adviser of an actively managed fund may actively buy or sell investments in the portfolio on a daily
basis without regard to conformity with an index. But the trades must be consistent with the overall
investment objective and strategies of the fund. An actively managed fund has the potential to
outperform the market or its chosen benchmark, but its performance is heavily dependent on the skill of
the manager.

What types of mutual funds are there?

Mutual funds fall into several main categories. Each type has different features, risks, and rewards.
 Stock funds invest primarily in stocks or equities. A stock is an instrument that represents an
ownership interest (called equity) in a company and a proportional share in the company’s assets and
profits. The types of stocks owned by a stock fund depend upon the fund’s investment objectives,
policies, and strategies. A stock fund’s value can rise and fall quickly (and dramatically) over the short
term. The fund’s performance depends on whether the underlying companies do well or not.
 Bond funds or income funds invest primarily in bonds or other types of debt securities. Depending on
its investment objectives and policies, a bond fund may concentrate its investments in a particular type
of bond or debt security or a mixture of types. The securities that bond funds hold will vary in terms of
risk, return, duration, volatility and other features.
 Target date funds typically hold a mix of stock funds, bond funds and other funds, and are created for
individuals with a particular date for retirement or other goal in mind. Target date funds are designed to
make investing for retirement or other goals more convenient by changing their investment mix as the
target date gets closer. However, be aware that if a target date fund invests in other funds, it may charge
a double layer of fees.
  Money market funds invest in liquid, short-term debt securities, cash and cash equivalents. Many
investors use money market funds to store cash or as an alternative to bank savings vehicles.

How do I buy and sell mutual funds?

Investors buy and sell mutual fund shares from/to the fund itself or through a broker or investment
adviser, rather than from/to other investors on national securities markets. The purchase price is the next
calculated NAV, plus any fees charged at the time of purchase. Mutual fund shares are redeemable. This means
investors can sell the shares back to the fund at any time at the next calculated NAV, minus any fees charged at
the time of redemption.

PORTFOLIO REVISION
Portfolio revision is the process of adjusting an investment portfolio by buying, selling, or reallocating
assets to realign it with investor goals, changing risk tolerance, and market conditions, with the aim of
maximizing returns and minimizing risk. It can involve active strategies with frequent trading or passive
strategies using predetermined rules, and is essential for maintaining a portfolio's effectiveness over time.

Need of Portfolio Revision

 Market Changes: Financial markets are dynamic; a portfolio that was once optimal can become less
effective over time due to shifting economic trends or investor sentiment.
 Investor's Personal Circumstances: An investor's risk tolerance, financial goals, or life circumstances
may change, requiring adjustments to the portfolio to match these new needs.
 Additional Funds: Receiving additional money (e.g., a bonus) may require revising the portfolio to
incorporate these new investments appropriately.

Process involved in portfolio revision

 Buying and Selling Securities: New assets are added, and existing ones are sold to change the
portfolio's composition.
 Rebalancing: Adjusting the proportion of funds invested in different assets to return to a target asset
allocation, such as the 50/50 split example in stocks and bonds.

Types of Revision Strategies

 Active Strategies: Involves frequent buying and selling of securities to try to "beat the market" and
generate higher returns through strategic adjustments.
 Passive Strategies: Uses predetermined formula plans, such as constant rupee value plans or constant
ratio plans, to make minor, systematic adjustments to the portfolio.

Factors to Consider
 Transaction Costs and Taxes: Frequent revisions can increase costs (like brokerage fees) and taxes,
which can erode returns.
 Liquidity: Ensure that the portfolio maintains sufficient liquidity, allowing the investor to access funds
when needed.
 Diversification: Maintaining proper diversification remains crucial to manage risk effectively.
 Regulatory Compliance: Portfolio managers must ensure that portfolio changes comply with relevant
legal and regulatory requirements.

FORMULA PLANS
Formula Plans are certain predefined rules and regulations deciding when and how many assets an
individual can purchase or sell for portfolio revision. Securities can be purchased and sold only when there are
changes or fluctuations in the financial market.

Why Formula Plans?

 Formula plans help an investor to make the best possible use of fluctuations in the financial market.
One can purchase shares when the prices are less and sell off when market prices are higher.
 With the help of Formula plans an investor can divide his funds into aggressive and defensive portfolio
and easily transfer funds from one portfolio to other.
How Formula Plans Work
1. Portfolio Division: The investor first divides their funds into two types of portfolios:
 Aggressive Portfolio: Consists of high-growth assets like equity shares.
 Defensive Portfolio: Contains stable, low-fluctuation assets such as bonds and debentures.
2. Predetermined Rules: Formula plans provide specific rules for rebalancing these portfolios when
market conditions change.
3. Goal: To profit from market fluctuations by buying low and selling high and transferring funds
between the aggressive and defensive portfolios as needed, based on set triggers.
Types of Formula Plans
 Constant Rupee Value Plan:
 Objective: To keep the total value of the aggressive portfolio (e.g., equities) constant over time.
 Mechanism: When the aggressive portfolio's value increases due to rising stock prices, the investor
sells some of the aggressive assets and moves the proceeds to the defensive portfolio. Conversely,
when prices fall, the investor buys more aggressive assets using funds from the defensive portfolio
to bring the aggressive portion back to its original value.
 Constant Ratio Plan:
 Objective: To maintain a fixed ratio between the aggressive and conservative portions of the
portfolio.
 Mechanism: After setting a desired ratio (e.g., 1:1), the investor rebalances the portfolio if the
actual ratio deviates significantly. This might involve selling aggressive assets and buying
defensive ones if the aggressive portion grows too large, or vice versa, to restore the desired ratio.
 Dollar Cost Averaging:
 Objective: To reduce the average cost of buying securities by making fixed-amount
investments at regular intervals.
 Mechanism: An investor commits to buying a specific amount of a stock or mutual fund
regularly, regardless of its price. This results in buying more units when prices are low and
fewer units when prices are high, leading to a lower average purchase price over time.

UNIT-V COMPLETED