MODULE 3: STOCK SELECTION AND PORTFOLIO

CONSTRUCTION
Stock Selection: Fundamental Analysis – Economy Analysis, Industry Analysis,
Company Analysis and Stock Valuation. Technical Analysis. Efficient Market
Hypothesis. Portfolio Construction: Calculation of Return and Risk, Decomposition of
Risk. Portfolio Construction Theories –Markowitz Theory, Sharpe’s Single Index
Model, Capital Asset Pricing Model, Arbitrage Pricing Theory.

SECURITY ANALYSIS
FUNDAMENTAL ANALYSIS:
Fundamental analysis is the study of economic factors, industrial environment and the factors
related to the company. The earnings of the company, the growth rate and the risk exposure
of the company have a direct bearing on the price of the share. These factors in turn rely on
the host of other factors like economic development in which they function, the industry
belongs to, and finally companies’ own performance. The fundamental school of thought
appraised the intrinsic value of shares through
Economic Analysis
 Industry Analysis
 Company Analysis

ECONOMIC ANALYSIS:
The state of the economy determines the growth of gross domestic product and investment
opportunities. An economy with favourable savings, investments, stable prices, balance of
payments, and infrastructure facilities provides a best environment for common stock
investment. If the company grows rapidly, the industry can also be expected to show rapidly
growth and vice versa. When the level of economic activity is low, stock prices are low, and
when the level of economic activity is high, stock prices are high reflecting the prosperous
outlook for sales and profits of the firms. The analysis of macro-economic environment is
essential to understand the behaviour of the stock prices. The commonly analysed macro-
economic factors are as follows:

Gross domestic product (GDP): GDP represents the aggregate value of goods and services
produced in the economy. It consists of personal consumption expenditure, gross private
domestic investment and government expenditure on goods & services and net export of
goods & services. It indicates rate of growth of economy. The estimate on GDP available on
annual basis
Business Cycle:
Business cycles refer to cyclical movement in the economic activity in a country as a whole.
An economy marching towards prosperity passes through different phases, each known as a
component of a business cycle. These phases are: a. Depression: Demand level in the
economy is very low. Interest rates and Inflation rates are high. These affect profitability and
dividend pay-out and reinvestment activities. b. Recovery: Demand level starts picking up.
Fresh investment by corporate firms shows increasing trend. c. Boom: After a consistent
recovery for a number of years, the economy starts showing signs of boom which is
characterized by high level of economic activities such as demand, production and profits. d.
Recession: The boom period is generally not able to sustain for a long period. It slows down
and results in the recession.

Savings & investment:

The growth requires investment which in turn requires substantial amount of domestic
savings. Stock market is a channel through which the savings of investors are made available
to the corporate bodies. Savings are distributed over various assets like equity shares,
deposits, mutual fund unit, real estate and bullion. The saving and investment pattern of the
public effect the stock to great extent.

Inflation:
The inflation is raise in price, where its rate increases, than the real rate of growth would be
very little. The demand is the consumer product industry is significantly affected. The
industry which comes under the government price control policy may lose the market. If the
mild level of inflation, it is good to the stock market but high rate of inflation is harmful to
the stock market.

Interest rates:
The interest rate affects the cost of financing to the firms. Higher interest rates increase the
cost of funds and lower interest rates reduce the cost of funds resulting in higher profit. There
are several reasons for change in interest rates such as monetary policy, fiscal policy,
inflation rate, etc

Monetary Policy, Money supply and Liquidity:

The liquidity in the economy depends upon the money supply which is regulated by the
monetary policy of the government. RBI regulate the money supply and liquidity in the
economy. Business firms require funds for expansion projects. The capacity to raise funds
from the market is affected by the liquidity position in the economy. The monetary policy is
designed with an objective to maintain a balance in liquidity position. Neither the excess
liquidity nor the shortage are desirable. The shortage of liquidity will tend to increase the
interest rates while the excess will result in inflation.
Budget:
The budget draft provides an elaborate account of the government revenues and expenditures.
A deficit budget may lead to high rate of inflation and adversely affect the cost of production.
Surplus budget may result in deflation. Hence, balanced budget is highly favourable to the
stock market.

Tax structure:
Every year in March, the business community eagerly awaits the government’s
announcement regarding the tax policy. Concessions and incentives given to the certain
industry encourage investment in particular industry. Tax relief given to savings encourages
savings. The minimum alternative tax (MAT) levied by finance minister in 1996 adversely
affected the stock market. Ten years of tax holiday for all industries to be set up in the
northeast is provided in the 1999 budget. The type of tax exemption has impact on the
profitability of the industries.

Monsoon and agriculture:

Agriculture is directly and indirectly linked with the industries. For example, sugar, cotton,
textile and food processing industries depend upon agriculture for raw material. Fertilizer and
insectide industries are supplying inputs to agriculture. A good monsoon leads to higher
demand for input and results in bumper crop. This would lead to buoyancy in the stock
market. When the monsoon is bad, agricultural and hydro power production would suffer.
They cast a shadow on a share market.

Infrastructure facilities:
Infrastructure facilities are essential for the growth of industrial and agricultural sector. A
wide network of communication system is a must for the growth of the economy. Good
infrastructure facilities affect the stock market favourably. The government are liberalized its
policy regarding the communication, transport and power sector.

Demographic factors:
The Demographic data provides details about the population by age, occupation, literacy and
geographic location. This is needed to forecast the demand of customer goods. The
population by age indicates the availability of able work force.

Economic forecasting:
To estimate the stock price changes, an analyst the macro economic environment and the
factor peculiar to industry concerned to it. The economic activities affect the corporate
profits, Investors, attitude and share prices.

Economic indicators:
The economic indicators are factors that indicate the present status, progress or slowdown of
the economy. They are capital investment, business profits, money supply, GNP, interest rate,
unemployment rate, etc. The economic indicators are grouped into leading, coincidental and
lagging indicators. The indicators are selected on the following criteria Economic
significance, Statistical adequacy, Timing, conformity

Diffusion index:
Diffusion index is a composite index or consensus index. The diffusion index consist of
leading, coincidental and lagging indicators. This type of index has been constructed by the
National Bureau of Economic Research in USA. But it is complex in nature to calculate and
the irregular movements that occur in individual indicators cannot be completely eliminated.
Econometric model building:
For model building several economic variables are taken into consideration. The assumptions
underlying the analysis are specified. The relationship between the independent and
dependent variables is given mathematically. While using the model, the analyst has to think
clearly all inter-relationship between the variables. This model use simultaneous equations.

Other factors:
a. Industrial growth rate 5
b. Fiscal policy of the Government
c. Foreign exchange reserves
d. Growth of infrastructural facilities
e. Global economic scenario and confidence
f. Economic and political stability.

INDUSTRY ANALYSIS
An industry is a group of firms that have similar technological structure of production and
produce similar products. E.g.: food products, textiles, beverages and tobacco products, etc.
These industries can be classified on the business cycle i.e. classified according to their
relations to the different phases of the business cycle. They are classified into
 Growth industry

 Cyclical industry

 Defensive industry

 Cyclical Growth industry

Growth industry:
The growth industry has special features of high rate of earnings and growth in expansion,
Independent of the business cycle. The expansion of the expansion of the industry mainly
depends upon the technological change.
Cyclical industry:
The growth and the profitability of industry move along with the business cycle. During the
boom period they enjoy the growth and during depression they suffer set back.

Defensive industry:
Defensive industry defies the movement of business cycle. The stock of defensive industries
Can be held by the investor for income earning purpose. They expand and earn income in the
Depression period too, under the governments of production and are counter-cyclical in
nature.

Cyclical Growth industry

This is a new type of industry that is cyclical and at the same time growing. The changes in
Technology and introduction of new models help the automobile industry to resume their
growth path.

INDUSTRY LIFE CYCLE

The life cycle of the industry is separated into four well defined stages such as
1. Pioneering stage
2. Rapid growth stage
3. Maturity and stabilization stage
4. Declining stage

Pioneering stage:
The prospective demand for the product is promising in this stage and the technology of the
product is low. The demand for the product attracts many producers to produce the particular
product. There would be severe competition and only fittest companies this stage. The
producers try to develop brand name, differentiate the product and create a product image.
This would lead to non-price competition too. The severe competition often leads to the
change of position of the firms in terms of market shares and profit. In this situation, it is
difficult to select companies for investment because the survival rate is unknown.

Rapid growth stage:

This stage starts with the appearance of surviving firms from the pioneering stage. The
companies that have withstood the competition grow strongly in market share and financial
performance. The technology of the production would have improved resulting in low cost of
productions and good quality products. The companies have stable growth rate in this stage
and they declare dividend to the share-holders. It is advisable to invest in the shares of these
companies.

Maturity and stabilization stage:

In the stabilization stage, the growth rate tends to moderate and the rate of growth would be
more or less equal to the industrial growth rate or the gross domestic product growth rate.
Symptoms of obsolescence may appear in the technology. To keep going, technological
innovations in the production process and products should be introduced. The investors have
to closely monitor the events that take place in the maturity stage of the industry.

Declining stage:
In this stage, Demand for the particular product and the earnings of the companies in the
industry decline. The specific feature of the declining stage is that even in the boom period;
the growth of the industry would be low and decline at a higher rate during the recession. It is
better to avoid investing in the shares of the low growth industry even in the boom period.
Investment in the shares of these types of companies leads to erosion of capital.

KEY FACTORS IN INDUSTRY ANALYSIS:

1. The past performance of the industry.
2. The performance of the product and technology of the industry.
3. Role of government in the industry.
4. Labour conditions relating to the industry.
5. Competitive conditions in the market
6. Inter-linkages with other industries

DETERMINING THE SENSITIVITY OF THE INDUSTRY:

1. Sensitivity to sales.
2. Operating leverage
3. Financial leverage.
SWOT ANALYSIS FOR THE INDUSTRY

Strength:
Strength of the industry refers to its capacity and comparative advantage in the economy.
For example, the existing research and development facilities and greater dependence on
allopathic Drugs are two elements of strength to the pharmaceutical industry in India.
Weakness:
Weakness refers to the restrictions and inherent limitations in the industry, which keep
The industry away from meeting its target. For example, Lack of infrastructure facility, rail-
road Links, etc., are weakness of the tourism industry in India.
Opportunities:
Opportunities refers to the expectation of favourable situation for an industry. For Example,
with increase in purchasing power with the people, demand for pharmaceutical industry will
increase and likewise, changing preference from gold to diamond jewellery has brought a lot
of Opportunities for the diamond industry.
Threats:
Threat refers to an unfavourable situation that has a potential to endanger the existence of an
industry. For example, after liberalization of import policy in India, import of Chinese goods
has threatened many industries in India, such as toys, novelties, etc.

III. COMPANY ANALYSIS

Effect of a business cycle on an individual company may be different from one industry to
another. Here, the main point is the relationship between revenues and expenses of the firm
and the economic and industry changes. The basic objective of company analysis is to
identify better performing companies in an industry .These companies would be identified for
investment. The processes that may be taken up to attain the objective are as follows:

1. Analysis of management of the company to evaluate its trust-worthiness, capacity and

Efficiency.
2. Analyse the financial performance of the company to forecast its future expected
earnings.
3. Evaluation of long-term vision and strategies of company in terms of organizational
strength and resources of company.
4. Analysis of key success factor for particular industry

SOURCES OF INFORMATION:
Information and data required for analysis of earnings of a firm are primarily available in the
annual financial statements of the firm. It include,
 Balance sheet or Position statement
 Income statement or Profit & Loss account.
 Financial statement analysis (Ratio analysis)
 Cash flow statement, the statement of sources and uses of cash and also
 Top level management people in the company.
I.BALANCE SHEET (BS):

It is the most significant and basic financial statement of any firm. It is prepared by a firm to
present a summary of financial position at a given point of time, usually at the end of
financial year. It shows the state of affairs of the firm at a point of time. In fact, the total
assets must be equal to the total claim against the firm and this can be stated as,

Total assets =Total claim (Debt +Shareholders)

=Liabilities +Shareholders equity

The different items contained in BS can be grouped into,

1. Assets

2. Liabilities

3. Shareholder’s funds

a. ASSETS: An asset of the firm represents the investments made by the firm in order to
generate earnings. It can be classified into (a).Fixed Asset (b).Current assets.

FIXED ASSET – Those which are intended to be for a longer period .These are permanent
in nature, relatively less liquid and are not easily converted into cash in short run. Fixed asset
include, plant & machinery, furniture & fixtures, buildings, etc. The value of fixed asset is
known as book value, which may be different from market value or replacement cost of the
assets. The amount of depreciation is an on-cash expense and does not involve cash out flow.
It is taken as an expense item and is included in the cost of goods sold or indirect expense.

CURENT ASSET - It is the liquid asset of the firm and is convertible into cash within a
period of one year. It includes cash and bank balance, receivables, inventory (raw material,
finished goods, etc), prepaid expenses, loan, etc.
LIABILITIES: It is also called as debts. It is claimed by the outsiders against the assets of
the firm. The liabilities refer to the amount payable by the firm to the claim holders. The
liabilities are classified into long term and short term liabilities.

LONG TERM LIABILITIES: It is the debt incurred by the firm, which is not payable
during the period of next one year. It represents the long term borrowings of the firm.

CURRENT LIABILITITES: It is the debt which the firm expects to pay within a period of
one year. It is related to the current assets of the firm in the sense that current liabilities are
paid out of the realization of current assets.

SHAREHOLDERS EQUITY (SE): It represents the ownership interest in the firm and
reflects the obligations of the firm towards its owners. It the direct contribution of the
shareholders to the firm.The retained earnings on the other hand reflects the accumulated
effect of the firms earnings. SE is also called as net worth. The liabilities and the SE must be
equal to the total assets of the firm.

II.INCOME STATEMENT OR PROFIT & LOSS ACCOUNT (IS):

It shows the result of the operations of the firm during a period. It gives detail sources of
income and expenses; Income statement is a flow report against the balance sheet which is a
stock report or status report. It helps in understanding the performance of the firm during the
period under consideration. It can be grouped into three classes. (i) Revenues (ii) Expenses &
(iii) Net profit or loss

REVENUES- It is the inflow of resources\cash that arise because of operation of the firm.
The revenue arises from the sale of goods and services to the customer and other non-
operating incomes. The firm may also get revenue from the use of its economic resources
elsewhere. E.g. – some of the 10 funds might have been invested in some other firm. The
income by way of interest or dividend is also a revenue.

EXPENSES- The cost incurred in the earning the revenues is called the expenses. Expenses
like, salaries, general expenses, repairs, etc. It occurs when there is a decrease in assets or
increase in liabilities

III.CASH FLOW STATEMENT AND FUND FLOW STATEMENT:

The balance sheet and the income statement are the two common financial statements and are also
known as traditional financial statements. It is essential to know the movement of cash during the
period. It is a historical record of where the cash came from and how was it used.
IV. FINANCIAL STATEMENT ANALYSIS:
Financial statement analyses are ratio like:
 Profitability ratios
 Liquidity ratios
 Solvency ratios

TECHNICAL ANALYSIS

It is a process of identifying trend reversal at earlier stages to formulate the buying and selling
strategy. With the help of various indicators they analyse the relationship between price& volume,
supply & demand, etc. An investor who does this analysis is called technician.

ASSUMPTIONS:

1. The market value is determined by the interaction of supply and demand.

2. The market discounts everything. The information regarding the issuing of bonus shares and
Right issues may support the prices. These are some of the factors which cause shift in
demand & Supply and change in direction of trends.
3. The market always moves in trend, except for certain minor deviations. The trend may either
be increasing or decreasing. It may continue in same manner or reverse.
4. In the rising market, many purchase shares in greater volume. When the market moves
down, people are interested in selling it. The market technicians assume that past prices
predict the future

PORTFOLIO MANAGEMENT

INTRODUCTION

“Never put all your eggs in one basket” is what is meant by diversification. Instead of investing all
funds in one asset, the funds be invested in a group of assets.

Diversification helps in reducing the risk of investing. Total risk of one investment is the sum of the
impact of all the factors that might affect the return from that investment. However, investors need
not suffer risk inherent with individual investments as it could be reduced by holding a diversity of
investments.

For example, return from a single investment in a cold drink company is subject to weather
conditions. This investment is a risky investment. However, if a second investment can be made in
an umbrella company, which is also subject to weather changes, but in an opposite way, the return
from the portfolio of two investments will have a reduced risk-level. This process is known as
diversification.

Portfolio is the combination of securities or diversified investment in securities.

Diversification may be Random or Efficient diversification.

In Random diversification, an investor may randomly select the portfolio without analysing the

Risk and return of the securities.

In Efficient diversification, an investor may construct a portfolio by carefully studying and

Analysing the risk and return of individual securities and also of its portfolio.

APPROACHES IN PORTFOLIO CONSTRUCTION:

 Traditional Approach
 Modern Approach

1. STEPS IN TRADITIONAL APPROACH:

 Analysis of constraints: Analysing the constraints like, income needs, liquidity, time
horizon, safety, tax consideration and risk temperament of an investor.
 Determination of objectives: The objective of the portfolio range from income to
capital appreciation. Investor has to decide upon the return which he gets from the
portfolio like, current income, growth in income, capital appreciation and so on.
 Selection of Portfolio: a) Selecting the type of securities for investment i.e. Shares
and Bonds or Bonds or Shares, b) Calculating the risk and return of the securities and
c)Diversifying the investment by selecting the securities combination and its
proportion of investment in that securities.

2. MODERN APPROACH:

The traditional approach is a comprehensive job for the individual. In modern approach,
gives more attention on selecting the portfolio i.e. Markowitz Model as well as CAPM.

PORTFOLIO MANAGEMENT:
Portfolio management may be defined as the process of construction, maintenance, revision
and evaluation of a portfolio.

The objective of portfolio management is to build a portfolio which gives a return

commensurate with the risk preference of the investor

Portfolio management specifically deals with security analysis, analysis and selection of
portfolio, revision of portfolio and evaluation of portfolio.
POINTS TO BE CONSIDERED:
1. Deciding the number and type of security in the portfolio.
2. Deciding on the proportionate amount of investment in each security.
3. Develop the various combinations of portfolio based on risk and return of portfolio.
4. Select one combination using Markowitz Model or Capital Asset Pricing Model
(CAPM).
5. Evaluate the performance of the portfolio using Treynor’s, Sharpe’s or Jensen’s
Model.
6. Periodical revision of the portfolio in order to maximize the portfolio returns.

PORTFOLIO SELECTION

INTRODUCTION

Risk and return are two basic factors for construction of a portfolio. While constructing a portfolio,
an investor wants to maximize the return and to minimize the risk. The risk can be reduced by
diversification. A portfolio which has highest return and lowest risk is termed as an optimal portfolio.
The process of finding an optimal portfolio is known as the portfolio selection.

If the investments can be made with certainty of returns, then the returns from different
investments would be the only consideration for making portfolio. However, in case of uncertainty,
decision regarding investments cannot be made only on the basis of returns. Risk (uncertainty)
should also be considered. The following are the theoretical relationship between the risk and return
and can be used to construct a portfolio.

 MARKOWITZ MODEL or PORTFOLIO THEORY

 CAPITAL ASSET PRICING MODEL

MARKOWITZ MODEL or PORTFOLIO THEORY

In order to select the best portfolio, an investor can use the Markowitz Portfolio Model. The
development of Portfolio theory is given by Harry Markowitz (HM) in1952 in Journal of Finance. He
has provided a conceptual framework and analytical tool for selection of an optimal portfolio. As the
HM Model is based on the expected returns (mean) and standard deviation (variance) of different
portfolios, this model is also called as Mean-Variance Model.

ASSUMPTIONS:

1. The investor should invest only in risky securities; this means no investment should be made
in risk-free securities.
2. The investor should use his own funds. Borrowed funds are not allowed for investments.
 3. The decision of the investor regarding selection of the portfolio is made on the basis of
expected returns and risk of the portfolio:

Return:

n_
Rp = ∑ Ri Wi
i=1

Risk:
SDp=√ (¿ x) 2(SD)2+(¿ y) 2(SD)2+2(¿ x )(¿ y)(Covariancexy )
4. For a given level of risk, an investor prefers maximum return than lower return and likewise,
for a given level of return, the investor prefers lower risk than higher risk.

Harry Markowitz Model is presented in 3 steps:

I. Setting the Risk-Return opportunity set:

The process of selection of optimum portfolio starts with the identification or construction of the
opportunity set of various portfolios in terms of risk and return of each portfolio. For example, ‘x’
number of securities are available in which an investor can invest his funds and infinite number of
combinations of all or a few of these securities are possible. Each such combination has an expected
average rate of return and risk. All these portfolios with a relative set of risk and return, when
plotted on graph, may look like as below:

RISK-RETURN OF NUMBER OF POSSIBLE PORTFOLIOS

The Shaded area AEHA includes all possible combinations of risk and return of portfolios and a
particular combination can be identified with a set of risk and return e.g., combination R represents
a risk level of r1, and the return level of r2.

Now the investor has to identify the best portfolio for which he has to identify the efficient set.

II. Determining the Efficient Set:

Efficient Portfolio is one which provides the maximum expected return for any particular degree of
risk. Thus, setting the Efficient Set will be subject to two prepositions:

a) Out of the portfolios with the equal expected return, an investor would prefer that which has
lowest risk; and

b) Out of the portfolios that have same degree of risk, and investor would prefer that which has
highest expected return

As the investors are rational and risk averse, they would prefer more return and lesser risk. In the
above diagram, the portfolios which lie along the boundary AGEH are efficient portfolios and it is
also called as Efficient Frontier.

For e.g., given level of risk r3, there are three portfolios L, M and N. But the portfolio L is an efficient
portfolio because for a given level of risk r3, it has the highest return and it lies on the boundary
AGEH.

Out of these three portfolios, L, M and N, the portfolio L is called the dominating portfolio because it
is having maximum expected return. Dominance is a situation in which investors prefers a portfolio
for investment that dominates all others. Portfolios lying on the efficient frontier are all dominating
portfolios

III. Selecting the Optimal portfolio:

In order to select the best portfolio or the optimal portfolio, the risk-return preferences of the
investor are to be analysed.
A highly risk averse investor will hold a portfolio on the lower left-hand segment of the
efficient frontier. However, risk taker investor will hold a portfolio on the upper position on
the right-hand side

HM Model does not specify one optimum portfolio. To select the expected risk-return combination
that will satisfy investor’s preferences, indifference curves or utility curves are used. All the
investors’ satisfaction level is not same. An investor is indifferent to various combinations of risk and
return and hence, the name indifference curve. The following figure shows the risk-return
indifference curves or for the investors.

All points lying on a particular indifference curve represent different combinations of risk and return
which provide same level of utility or satisfaction to the investors. The indifference curves show the
investor’s risk-return trade-off. The steeper the slope, the more risk averse the investor is.

An investor may have, at present, a satisfaction level represented by the indifference curve C1, but if
the satisfaction level increases, then the investor will move to indifference curve C2 or C3. Thus, an
investor at any particular point of time, will be indifferent between combinations S1 and S2 or S3
and S4 or S5 and S6.

The indifference curves never intersect each other and the shape of the curves may vary depending
on the risk preferences of the investors.

Once the shape of investor’s indifference curve is determined, an investor should match his risk
return preference (indifference curve) with the best portfolios available (efficient frontier). Given the
efficient frontier and risk-return indifference curves, the investor’s optimal portfolio is found at the
tangency point of efficient frontier with the indifference curve. This tangency point marks the
highest level of satisfaction, the investor can attain is shown below:

EFFICIENT FRONTIER AND OPTIMAL PORTFOLIO

R is the tangency point and also the efficient portfolio. At this portfolio, the investor will be able to
get best possible level of satisfaction and also the best combination of risk and return. Combinations
‘X’ and ‘Y’ are not optimal because they lie outside and inside the region.
Limitations of Harry Markowitz Model:

Risky securities alone taken for investment.

2. It requires large amount of input data. An investor must obtain estimates of return, variance
of return and covariance of returns for each pair of securities included in the portfolio. For ex.
If there are ‘N’ number of securities in the portfolio, then ‘N’ estimates of return, variances
and (N2 -N)/2 estimates of covariance’s are required. For ex. For 4 securities 42 -4/2 i.e. 6
covariance’s are estimated and for 10 securities 102-10/2 i.e. 45covariances are estimated.
3. HM Model complex and ‘N’ number of computations are required.

CAPITAL ASSET PRICING MODEL (CAPM)

CAPM is an extended version of Markowitz Model. In the HM Model we assume that the investor
invests in risk-free securities and investors not use borrowed funds. The CAPM overlook these 2
assumptions. That means CAPM studies the nature of risk and return of a portfolio when an investor
uses borrowed funds and also invests in risk-free securities.

The total CAPM Model explained under two broad segments:

I. Capital Market Line (CML)
II. Security Market Line (SML)

Assumptions:

1. The investors are basically risk averse and diversification is needed to reduce the risk.
2. All investors want to maximize the return and choose a portfolio solely on the basis of
3. Risk and return assessment.
4. All investors can borrow or lend an unlimited amount of funds at risk-free rate of
interest
5. (Risk-free lending and risk-free borrowing).
6. .All investors have same estimates of risk and return of all securities.
7. .All securities are perfectly divisible and liquid and there is no transaction cost or tax.
8. There is a perfect competition in the market.
9. All investor are efficiently diversified and have eliminated the unsystematic risk.
Thus,
10. Only the systematic risk is relevant in determining the estimated return.

I. Capital Market Line (CML):

The introduction of risk-free investment and borrowing creates a new set of expected risk-
return possibilities which did not exist earlier. This new trade-off is represented by the
straight line IRFN in the following diagram. This line IRFN is called the CML.
II. Security Market Line (SML):

SML is an extension of CML. In CML Standard Deviation σ includes the Systematic and Unsystematic
Risk. But Unsystematic Risks are diversifiable and can be eliminated by efficient diversification.
Systematic risks are non-diversifiable and can be measured by β, the beta factor.

1. β value less than 0 (Negative β):

It indicates a negative (inverse) relationship between stock return and market return.
Negative β means that if market goes up, the prices of that security are likely to go down. It
is possible but quite unlikely

2. 2. β value zero:
It means that there is no systematic risk and the share prices have no relationship with the
market. It is very unlikely. Total investment is made in risk-free securities.

3. β value between 0 and 1:

The investment is made out of own funds (i.e. defensive portfolio). Particular stock has less
volatility than the market. In case of rise or fall, share price will show lesser fluctuations than
market.

4. β value 1:
It means that volatility in share price and market is equal. Total investment is made in risky
securities.
5. β value more than 1:
It means that the stock has a higher volatility than the market. Fluctuation in share price will
be more than the fluctuation in the market index. Investment is made out of borrowed
funds (i.e. aggressive portfolio) also.

The line which shows the values of risk and return combinations of the defensive and aggressive
portfolio is called Security Market Line which is depicted below:

Ri = Rf + β (RM – Rf)

The portfolio that contains all the securities in the economy is called the market portfolio.
The CAPM model depicts that the expected rate of return of a security consists of two parts
i.e. 1) the risk-free interest rate IR f and 2) the risk premium (Rm – Rf) β. The risk premium is
equal to the difference between the expected market return and the risk-free interest rate
multiplied by the beta factor, β. The higher the beta factor, the greater is the expected rate of
return RS and vice-versa.
(Calculations refer class notes)

Limitations of CAPM:

1. Beta calculation difficult (tedious).

2. Assumptions are hypothetical and are impractical.

3. Required rate of return is only a rough approximation.

Measures of Portfolio Performance:

There are several measures for evaluation of portfolio performance. They are

I. Return per unit of risk:

The return earned over and above the risk-free return is the risk-premium and is earned
for bearing risk. The risk-premium may be divided by risk factor to find out the reward
per unit of risk undertaken. This is also known as reward to risk ratio. There are two
methods of measuring reward to risk ratio:

Sharpe Ratio (Reward to Variability Ratio) : The Sharpe Index measures the risk premium of the
portfolio relative to the total amount of risk in the portfolio. The larger the index value, the better
the portfolio has performed

RP – IRF
Sharpe Ratio = ------------
σP

b) Treynor Ratio (Reward to Volatility Ratio):

The Treynor Index measures the risk premium of the portfolio related to the amount of systematic
risk present in the portfolio

RP – IRF
Treynor Ratio = -----------
βP

II.Differential Return:

c) Jensen Ratio:

Michel Jensen has developed another method for evaluation of performance of a portfolio. This
measure is based on differential returns. The Jensen’s Ratio is based on the difference between the
actual return of a portfolio and required return of a portfolio in view of the risk of the portfolio.

α
Jensen’s Index = -----
β
Ri= IRf + (RM – IRF) β

(Note: Caln. refer class work)