1

Security Analysis & Portfolio Management

Rohit Soodn

Risk & Return

 Course Outcomes
2

 Appraise with the relation between risk and return.

 Enumerate and identify different types of risks in security

analysis

 Explain what the standard deviation of returns is, explain

why it is especially useful in finance, and be able to
calculate it

 Explain what an expected return is, and calculate the

expected return for an asset
• The Expected Value:
The expected value of a
distribution is the most
likely outcome

• For the normal dist., the

expected value is the same
as the arithmetic mean E(R)


• All other things being equal,
we assume that people
prefer higher expected
E R   t R t
returns t 1
 The Expected Return: An Example
• Suppose that a
particular investment 60%

Probability
40%
has the following
20%
probability distribution: 0%
– 25% chance of -5% -5% 5% 15%
Rate of Return
return
– 50% chance of 5% return
– 25% chance of 15%
return
• This investment has an
expected return of
 The Variance & Standard Deviation

• The variance and

Less Risky
standard deviation
Riskier
describe the dispersion
(spread) of the potential
outcomes around the

 
N
expected value 2
• Greater dispersion  
2
R t R t  R
generally means greater t 1
uncertainty and
therefore higher risk R   2
R
 • Standard Deviation: The n
formula for the standard
deviation when analyzing  (k i  ki ) 2

population data (realized  i 1

returns) is: n

The formula for the standard

deviation when analyzing
n

 (k
forecast data (ex ante returns)
is:it is the square root of the  i  k i ) Pi
2

sum of the squared deviations i 1

away from the expected value.
Question
• Calculate the variance and standard deviation
of returns, if the return from a stock over a 6
period is as follows (in Percent):
– R1= 15,
– R2= 12,
– R3= 20,
– R4= -10,
– R5= 14 and
– R6= 9
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 Question
• The return of X and Y under different market condition are
• Calculate expected return and standard deviation.
• If you want to X and Y or in both?

particulars boon normal recession

Probability .3 .5 .2

Rate of return 25 35 45
X

Rate of return 45 35 25
Y
Calculation of Expected return –
1. For X
R P Sum r*p
• Boon 25 .3 7.5
• Normal 35 .5 17.5
• Recession 45 .2 9
34
2.For Y
R P Sum r*p
• Boon 45 .3 13.5
• Normal 35 .5 17.5
• Recession 25 .2 5
36
 Calculation of Standard Deviation X
square root of=sum(r-rbar) sqaure*p
Standard deviation is square root of 49 =7

State R R bar or R- sqaure p P(R-

of Expected r RBAR
Econo return ba )
my r suare

Boon 25 34 -9 81 . 24.3 n
  (k  k ) P
3 2
normal 35 34 1 1 . .5 i i i
5
i 1
Recessi 45 34 11 121 . 24.2
on 2
49
• Standard deviation is square root of 49 =7

State R R bar R-r bar sqaure p

of or
Econo Expect
my ed
return

Boon 25 36 -9 81 .3 24.3

normal 35 36 -1 1 .5 .5

Recessi 45 36 11 121 .2 24.2

on

49
• So both the stocks have same risk but return is y
is 36 more than so y is preferable.
 QUESTION2
• The return of A and B under different market
condition are
• Calculate expected return and standard
deviation.
• If you want to A and B or in both?
probablity Security A SecurityB

.5 4 0
.4 2 3
.1 0 3
• The probability distribution of the rate of
return on Reliance company stock is given
below:

State of the Economy Probability of Occurrence Rate of Return

• Boom 0.20 30 %
• Normal 0.50 18 %
• Recession 0.30 9%
• What is the expected return and standard
deviation of return?
Mr. Rajesh, a marketing manager of ABC Ltd. has predicted the following
returns for his organization for the coming year.
Compute the expected return and degree of risk.

Economic Return Probability

Conditions
Excellent 22% .10

Good 20% .20

Average 15% .40

Below Average 12% .20

Bad 08% .10

 • Prerak Iron Ltd. is thinking of raising finance to
further its projects overseas. For this the
company is observing the other companies’
raising of finance. Their debt equity ratios are
being thoroughly studied by the financial experts
of the company.

• Prerak Iron Ltd. what caution do you think that the company should take?

• How Return on Investment would matter?

18
Discuss
• Rohan is having 10,00,000 to invest but not
been able to make his mind about investment
in Bank FD or Equities. He is coming to you for
resolving the said issue. Kindly Guide
Discuss
• Clive Rodney Megabucks offers your friend, Yunyoung, an interesting
gamble involving giving her the choice of the contents in one of two
sealed, identical-looking boxes. One box has $20,000 in cash and the
second has nothing inside. There is an equal probability that the chosen
box contains cash versus nothing. Yunyoung states that she would not
call off the gamble if you offered her a certain $4,999 instead of her
choice of box. However, she would be indifferent if $5,000 was offered in
place of the risky gamble; and she would definitely take $5,001 to call off
the gamble. We would describe Yunyoung as __________ in this
instance.
• being risk averse
• being risk indifferent
• having a risk preference
• Risk of two securities with different expected
return can be compared with:

a) Coefficient of variation
b) Standard deviation of securities
c) Variance of Securities
d) None of the above
• A portfolio comprises two securities and the
expected return on them is 12% and 16%
respectively. Determine return of portfolio if
first security constitutes 40% of total
portfolio.

a) 12.4%
b) 13.4%
c) 14.4%
d) 15.4%
• A risk free security has zero variance.

a) True
b) False
• Return on any financial asset consists of
capital yield and current yield.

a) True
b) False
• The firm of Sun and Moon purchased a share of Acme.com
common stock exactly one year ago for $45. During the past
year the common stock paid an annual dividend of $2.40. The
firm sold the security today for $85. What is the rate of return
the firm has earned?
• 5.3%
• 194.2%
• 88.9%
• 94.2%
• A set of possible values that a random
variable can assume and their associated
probabilities of occurrence are referred to as
__________.
• probability distribution
• the expected return
• the standard deviation
• coefficient of variation
• A statistical measure of the variability of a
distribution around its mean is referred to as
__________.
• a probability distribution
• the expected return
• the standard deviation
• coefficient of variation
• The weighted average of possible returns,
with the weights being the probabilities of
occurrence is referred to as __________.
• a probability distribution
• the expected return
• the standard deviation
• coefficient of variation
Risk Return Trade Off
 Beta
• A measure of the volatility, or systematic risk, of a
security or a portfolio in comparison to the market as
a whole.

• Beta is used in the capital asset pricing model

(CAPM), a model that calculates the expected return
of an asset based on its beta and expected market
returns.

• It measures a stock's relative volatility - that is, it

shows how much the price of a particular stock
jumps up and down compared with how much the
stock market as a whole jumps up and down.
 Beta

• An asset has a Beta of zero if its returns change independently of changes in

the market's returns.

• A positive beta means that the asset's returns generally follow the market's
returns, in the sense that they both tend to be above their respective
averages together, or both tend to be below their respective averages
together.

• A negative beta means that the asset's returns generally move opposite the
market's returns: one will tend to be above its average when the other is
below its average.
 Beta
• Beta is calculated using regression analysis, and you can think of
beta as the tendency of a security's returns to respond to swings
in the market.

• A beta of 1 indicates that the security's price will move with the
market.

• A beta of less than 1 means that the security will be less volatile
than the market.

• A beta of greater than 1 indicates that the security's price will be

more volatile than the market.

• For example, if a stock's beta is 1.2, it's theoretically 20% more

volatile than the market.
Value of Interpretation Example
Beta

β<0 Asset generally moves in the opposite direction as Gold, which often moves opposite to the movements of the
compared to the index stock market

β=0 Movement of the asset is uncorrelated with the Fixed-yield asset, whose growth is unrelated to the
movement of the benchmark movement of the stock market

Movement of the asset is generally in the same Stable, "staple" stock such as a company that makes soap.
0<β< direction as, but less than the movement of the Moves in the same direction as the market at large, but less
1 benchmark susceptible to day- to-day fluctuation.

Movement of the asset is generally in the same

β=1 direction as, and about the same amount as the A representative stock, or a stock that is a strong
movement of the benchmark contributor to the index itself.

Movement of the asset is generally in the same Volatile stock, such as a tech stock, or stocks which are
β>1 direction as, but more than the movement of the very strongly influenced by day-to- day market news.
benchmark
 Smart Beta

• Involves choosing, weighing and re-balancing stocks from the index

that suits your investment objective and risk-taking ability.

• Free-float market capitalization weights for Sensex/Nifty

• No fundamental factor such as earnings growth or valuation ratios

that is being taken into consideration while building such indices.

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 Return
Return is a motivating force and reward for investment.

Investor wants maximum return. Assessing return is important as

it helps:

• Comparison
• Analyzing past performance &
• Forecasting future returns.

• 1- Historical or realized return-It is return which investor actually

earned in the form of dividend and capital gain over a period of
time.

• 2- Expected return or Exante- It is return which investor

anticipates over a period of time.
1- Historic return:

It is percentage of return on opening market price of

security.
Rate of return=

Income earned + (end price – beginning price)*100

Buying price

OR
R= D1 + (P1- P0)*100
P0
2. Expected return or Exante:
Probability associated with future return.

• R bar or Expected Return=Sum of (P*R)

R=Expected Return
P=Probability of ith Return
R=Rate of Return from the proposal.
• The price of Equity Share Idea Cellular at the
beginning of the year Rs.60;dividend paid two
wards the end of the year is 2.40 and price at the
end of the year is 66.Compute the rate of return.

R= D1 + (P1- P0)*100
P0
R=2.4 + (66- 60)*100
60
R=14%
• India Zink is is evaluating return on two assets, A and B.A
was purchased a year ago for Rs.400000 and since than it
generated cash inflow of Rs.16000.Presently it can be sold
for price of 430000.

• Asset B was purchased a few year ago and its market value
in the beginning and at end of the year was 240000 and
Rs.236000 respectively. The asset B has generated cash
inflow of 34000 during the year. Find out the rate of return
on these Assets.

R= D1 + (P1- P0)*100
P0
For Assets A: 16000 + (430000- 400000)*100
400000
R=11.5%
For Assets B: 34000 + (236000- 240000)*100
240000
R=12.5%
 Thank you
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