CHAPTER-I

INTRODUCTION

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 RISK-RETURN ANALYSIS
MEANING:
Risk-Return Analysis opens the door to a groundbreaking four-book series giving readers a
privileged look at the personal reflections and current strategies of a luminary in finance. This
first volume is Markowitz's response to what he calls the "Great Confusion" that spread when
investors lost faith in the diversification benefits of MPT during the financial crisis of 2008. It
demonstrates why MPT never became ineffective during the crisis, and how you can continue
to reap the rewards of managed diversification into the future. Economists and financial
advisors will benefit from the potent balance of theory and hard data on mean-variance
analysis aimed at improving decision-making skills.

Relationship between risk and return

Investors are risk averse; i.e., given the same expected return, they will choose the investment
for which that return is more certain. Therefore, investors demand a higher expected return
for riskier assets. Note that a higher expected return does not guarantee a higher realized
return. Because by definition returns on risky assets are uncertain, an investment may not
earn its expected return.
Although the charts in Figure 1 show historical (realized) returns rather than expected
(future) returns, they are useful to demonstrate the relationship between risk and return. Note
that the mean (average) annual return increases as the dispersion of returns increases.

A portfolio is a collection of assets. The assets may be physical or financial like

Shares, Bonds, Debentures, Preference Shares, etc. The individual investor or a fund manager
would not like to put all his money in the shares of one company that would amount to great
risk. He would therefore, follow the age old maxim that one should not put all the eggs into
one basket. By doing so, he can achieve objective to maximize portfolio return and at the
same time minimizing the portfolio risk by diversification.

 Portfolio management is the management of various financial assets which comprise

the portfolio.

 Portfolio management is a decision – support system that is designed with a view to

meet the multi-faced needs of investors.

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  According to Securities and Exchange Board of India Portfolio Manager is defined as:
“Portfolio means the total holdings of securities belonging to any person”.
FUNCTIONS OF RISK-RETURN:
 To frame the investment strategy and select an investment mix to achieve the desired
investment objectives

 To provide a balanced portfolio which not only can hedge against the inflation but can
also optimize returns with the associated degree of risk

 To make timely buying and selling of securities

 To maximize the after-tax return by investing in various tax saving investment

instruments.

STRUCTURE / PROCESS OF TYPICAL PORTFOLIO MANAGEMENT

In the small firm, the portfolio manager performs the job of security analyst.
In the case of medium and large sized organizations, job function of portfolio manager and
secu
rity analyst are separate.

RESEARCH PORTFOLIO OPERATIONS

(e.g. Security (e.g. buying and
MANAGERS
Analysis) selling of Securities)

CLIENTS

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RISK AND EXPECTED RETURN:

There is a positive relationship between the amount of risk and the amount of expected return
i.e., the greater the risk, the larger the expected return and larger the chances of substantial
loss. One of the most difficult problems for an investor is to estimate the highest level of risk
he is able to assume.

 Risk is measured along the horizontal axis and increases from left to right.

 Expected rate of return is measured on the vertical axis and rises from bottom to
top.

 The line from 0 to R (f) is called the rate for return or risk less investments
commonly associated with the yield on government securities.

 The diagonal line from R (f) to E(r) illustrates the concept of expected rate of
return increasing as level of risk increases.

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TYPES OF RISKS:
Risk consists of two components. They are

1. Systematic Risk
2. Un-systematic Risk

1. Systematic Risk:

Systematic risk is caused by factors external to the particular company and uncontrollable by
the company. The systematic risk affects the market as a whole. Factors affect the systematic
risk are
 Economic conditions
 Political conditions
 Sociological changes

The systematic risk is unavoidable. Systematic risk is further sub-divided into three types.
They are
a. Market Risk
b. Interest risk
c. Purchasing power risk

a. Market Risk:

One would notice that when the stock market surges up, most stocks post higher price. On the
other hand, when the market falls sharply, most common stocks will drop. It is not
uncommon to find stock prices falling from time to time while a company’s earnings are
rising and vice-versa. The price of stock may fluctuate widely within a short time even
though earnings remain unchanged or relatively stable.

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b. Interest Rate Risk:

Interest rate risk is the risk of loss of principle brought about the changes in the interest rate
paid on new securities currently being issued.

c. Purchasing Power Risk:

The typical investor seeks an investment which will give him current income and / or capital
appreciation in addition to his original investment.

2. Un-systematic Risk:

Un-systematic risk is unique and peculiar to a firm or an industry. The nature and mode of
raising finance and paying aback the loans, involve the risk elements. Financial leverage of
the companies that is debt-equity portion of the companies’ differs from each other. All these
factors affect the un-systematic risk and contribute a portion in the total variability of the
return.

 Managerial inefficiency
 Technological changes in the production process
 Availability of raw materials
 Changes in the consumer preference
 Labour problems

The nature and magnitude of the above mentioned factors differ from industry to industry and
company to company. They have to be analyzed separately for each industry and firm. Un-
systematic risk can be broadly classified into:

a. Business Risk
b. Financial Risk

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a. Business Risk:

Business risk is that portion of the unsystematic risk caused by the operating environment of
the business. Business risk arises from the inability of a firm to maintain its competitive edge
and growth or stability of the earnings. The volatibility in stock prices due to factors intrinsic
to the company itself is known as Business risk. Business risk is concerned with the
difference between revenue and earnings before interest and tax. Business risk can be divided
into

i. Internal Business Risk

Internal business risk is associated with the operational efficiency of the firm. The operational
efficiency differs from company to company. The efficiency of operation is reflected on the
company’s achievement of its pre-set goals and the fulfillment of the promises to its
investors.

ii. External Business Risk

External business risk is the result of operating conditions imposed on the firm by
circumstances beyond its control. The external environments in which it operates exert some
pressure on the firm. The external factors are social and regulatory factors, monetary and
fiscal policies of the government, business cycle and the general economic environment
within which a firm or an industry operates.

b. Financial Risk:

It refers to the variability of the income to the equity capital due to the debt capital. Financial
risk in a company is associated with the capital structure of the company. Capital structure of
the company consists of equity funds and borrowed funds.

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MARKOWITZ MODEL:

Markowitz model is a theoretical framework for analysis of risk and return and their
relationships. He used statistical analysis for the measurement of risk and mathematical
programming for selection of assets in a portfolio in an efficient manner. Markowitz
approach determines for the investor the efficient set of portfolio through three important
variables i.e.

 Returns
 Standard deviation
 Co-efficient of correlation

Markowitz model is also called as a “Full Covariance Model”. Through this model the
investor can find out the efficient set of portfolio by finding out the trade off between risk and
return, between the limits of zero and infinity. According to this theory, the effects of one
security purchase over the effects of the other security purchase are taken into consideration
and then the results are evaluated.

Most people agree that holding two stocks is less risky than holding one stock. For example,
holding stocks from textile, banking and electronic companies is better than investing all the
money on the textile company’s stock.

Markowitz had given up the single stock portfolio and introduced diversification. The single
stock portfolio would be preferable if the investor is perfectly certain that this expectation of
highest return would turn out to be real. In the world of uncertainty, most of the risk averse
investors would like to join Markowitz rather than keeping a single stock, because
diversification reduces the risk.

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CHARACTERISTICS OF PORTFOLIO(Risk-Return):

Individuals will benefit immensely by taking portfolio management services for the following
reasons:
 Whatever may be the status of the capital market, over the long period capital markets
have given an excellent return when compared to other forms of investment. The
return from bank deposits, units, etc., is much less than from the stock market.

 The Indian Stock Markets are very complicated. Though there are thousands of
companies that are listed only a few hundred which have the necessary liquidity. Even
among these, only some have the growth prospects which are conducive for
investment. It is impossible for any individual wishing to invest and sit down and
analyze all these intricacies of the market unless he does nothing else.

 Even if an investor is able to understand the intricacies of the market and separate
chaff from the grain the trading practices in India are so complicated that it is really a
difficult task for an investor to trade in all the major exchanges of India, look after his
deliveries and payments

Finance is the science that describes the management, creation and study of money,
banking, credit, investments, assets and liabilities. Finance consists of financial
systems, which include the public, private and government spaces, and the study of
finance and financial instruments, which can relate to countless assets and liabilities.
Some prefer to divide finance into three distinct categories: public finance

The study of finance can also take many forms, depending on the field or area of
finance which one wishes to study. For instance, economics is considered a pillar of
financial science, where both macro and microeconomic factors affect virtually
levels of financial decisions and outcomes at all levels. Additionally, the study
of behavioral finance aims to study the more "human" side of a science considered
by most to be highly mathematical. This illustrates that the study of finance can, at
times, be more art than science

Financial Planning Standards Board India (FPSB) has called for regulating
investment advisors in India. In a paper submitted to the Securities and Exchange

9
Board of India (Sebi), FPSB has said that any individual or institution, who interacts
with the general public and gives 'financial advice', should be made accountable for
the advice given.

There are a lot of investment avenues available today in the financial market for an
investor with an investable surplus. He can invest in Bank Deposits, Corporate
Debentures, and Bonds

where there is low risk but low return. He may invest in Stock of companies where
the risk is high and the returns are also proportionately high. The recent trends in the
Stock Market have shown that an average retail investor always lost with periodic
bearish tends. People began opting for portfolio managers with expertise in stock
markets who would invest on their behalf. Thus we had wealth management services
provided by many institutions. However they proved too costly for a small investor.
These investors have found a good shelter with the mutual funds.

Mutual fund industry has seen a lot of changes in past few years with
multinational companies coming into the country, bringing in their professional
expertise in managing funds worldwide. In the past few months there has been a
consolidation phase going on in the mutual fund industry in India. Now investors
have a wide range of Schemes to choose from depending on their individual
profiles. My study gives an overview of mutual funds – definition, types, benefits,
risks, limitations, history of mutual funds in India, latest trends, global scenarios. I
have analyzed

a few prominent mutual funds schemes and have given my findings. Financial
services are the economic services provided by the finance industry, which
encompasses a broad range of businesses that manage money, including credit
unions, banks, credit card companies, insurance companies, accountancy companies,
consumer finance companies, stock brokerages, investment funds, real estate funds
and some government sponsored enterprises.

As of 2004, the financial services industry represented 20% of the market

capitalization of the S&P 500 in the United States. The U.S. finance industry
comprised only 10% of total non-farm business profits in 1947, but it grew to 50%

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by 2010. Over the same period, finance industry income as a proportion of GDP rose
from 2.5% to 7.5%, and the finance industry's proportion of all corporate income
rose from 10% to 20%

The Financial Risk Management to Business Success

Financial Risk management is an important part of planning for businesses. The
process of risk management is designed to reduce or eliminate the risk of certain
kinds of events happening or having an impact on the business.
Definition of Financial Risk Management
Financial Risk management is a process for identifying, assessing, and prioritizing
risks of different kinds. Once the risks are identified, the risk manager will create a
plan to minimize or eliminate the impact of negative events. A variety of strategies is
available, depending on the type of risk and the type of business. There are a number
of risk management standards, including those developed by the Project
Management Institute, the International Organization for Standardization (ISO), the
National Institute of Science and Technology, and actuarial societies.
Types of Financial Risk
There are many different types of risk that Financial risk management plans can
mitigate. Common risks include things like accidents in the workplace or fires,
tornadoes, earthquakes, and other natural disasters. It can also include legal risks like
fraud, theft, and sexual harassment lawsuits. Risks can also relate to business
practices, uncertainty in financial markets, failures in projects, credit risks, or the
security and storage of data and records.
Goals of Financial Risk Management
The idea behind using risk management practices is to protect businesses from being
vulnerable. Many business Financial risk management plans may focus on keeping
the company viable and reducing financial risks. However, risk management is also
designed to protect the employees, customers, and general public from negative
events like fires or acts of terrorism that may affect them. Risk management
practices are also about preserving the physical facilities, data, records, and physical
assets a company owns or uses.
Process for Identifying and Managing Financial Risk
While a variety of different strategies can mitigate or eliminate risk, the process for
identifying and managing the risk is fairly standard and consists of five basic steps.

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First, threats or risks are identified. Second, the vulnerability of key assets like
information to the identified threats is assessed. Next, the risk manager must
determine the expected consequences of specific threats to assets. The last two steps
in the process are to figure out ways to reduce risks and then prioritize the risk
management procedures based on their importance.

Strategies for Managing Financial Risk

There are as many different types of strategies for managing risk as there are types
of risks. These break down into four main categories. Risk can be managed by
accepting the consequences of a risk and budgeting for it. Another strategy is to
transfer the risk to another party by insuring against a particular, like fire or a slip-
and-fall accident. Closing down a particular high-risk area of a business can avoid
risk. Finally, the manager can reduce the risk’s negative effects, for instance, by
installing sprinklers for fires or instituting a back-up plan for data.
Having a risk management plan is an important part of maintaining a successful and
responsible company. Every company should have one. It will help to protect people
as well as physical and financial assets.

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NEED OF THE STUDY
1. To see that returns is maximized with minimum risk.

2. Combination of securities with different risk returns will constitute the portfolio
of the investor.

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OBJECTIVES OF THE STUDY
1. To study the Financial Risk analysis of BSE BankEx securities.
2. To identify and analyze the correlation between Banks returns with BSE BankEx
returns.
3. To examine and evaluate the growth prospects of BSE BankEx securities.
4. To identify profitable investment opportunities in Banking Sector Stocks.
5. To identify the return and risk of public and private banks listed on Bank Nifty.
6. To rank the stocks on the basis of returns.
7. To compare the performance of each stock against their benchmark index.
8. To measure the portfolio return and risk of public and private banks listed on
Bank Nifty

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METHODOLOGY
The risk and return relationship is a fundamental concept in not only financial
analysis, but in every aspect of life. If a decision has to lead to benefit maximization,
it is necessary that individuals/institutions consider the combined influence on
expected (future) return or benefit as well as on risk/cost. The requirement that
expected return/benefit is commensurate with risk/ cost is known as the “risk return
trade-off” in finance. A company which has a higher market price is not necessarily
the best stock to buy. It may have no growth prospects or it may be overpriced.
Similarly, a company that performs well during any one year may not be the best to
buy. On the contrary, a company which has been badly for some time might turn the
corner and it may be the best to buy, as its shares may be underpriced and it has
good prospects of growth, hence an analysis of risk or return guides an investor in
proper profitable investment. The risk and return trade off says that the potential
return rises with an increase in risk. It is important for an investor to decide on a
balance between the desire for the lowest possible risk and highest possible return.
Any rational investor, before investing his or her investible wealth in the stock,
analyses the risk associated with the particular stock. The actual return he receives
from a stock may vary from his expected return and the risk is expressed in terms of
variability of return.
SOURCES OF DATA:
Primary Data
The primary data has been collected from discussions with the officials of the
company.
Secondary Data
The secondary data for this study was collected from News Papers,
Magazines, Internet, and Text Books etc.

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SCOPE OF THE STUDY
1. The scope of the study limited to Eight Public Sector banks only.
2. To understand the causes, which leads to investment ideas.
3. To ascertain the technique for investing in banking sectors.
4. To calculate Returns, Standard Deviation, Beta, Alpha, Covariance and
Correlation.
5. The study was conducted to analyze the nifty movement behavior towards the
banking stocks. It also evaluates the performance of banking share stock mainly
the identification of required rate of return and risk of a particular stock based
upon different risk elements prevailing in the market and other economic factors.
This study is structured to analyse the performance of the selected shares in the
banking industry to reveal the risk and return in a particular period of time

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LIMITATIONS OF THE STUDY
1. A good number of explanatory variables must be taken into consideration in order
to assess the share price movement. But due to time constraints detailed analysis
of each bank were not made.
2. This being an academic study suffers from time and cost constraints
3. This is limited to BSE BANKEX.
4. This study is related to data collected from 3rd December, 2017 to 11th January,
2018.
5. During the study the Stock Market was Bullish.
6. Confidentiality of data – organizational constraints.
7. The analysis carried out and suggestions offered are limited to the researcher’s
ability to understand complex financial aspects.
8. Only 12 stocks listed on Bank Nifty are considered for the study and the study is
conducted only for one year time period.

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 CHAPTER-II
REVIEW OF LITERETURE

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 REVIEW OF LITERATURE
Name of the Article: Dedicated stock portfolios Portfolio managers may have been sitting
atop a sleeping giant for the past thirty-eight years - Markowitz optimization techniques are
about to come into their own.
Author Name: Robert A. Haugen and Nardin L. Baker
T he Markowitz portfolio model introduced in 1952 expressed the optimal relationship
between port- folio volatility and expected return. While the procedure was quite capable of
providing perfectly accurate answers to questions such as, “Given a population of securities,
what single combination would have had the lowest volatility in monthly return over the
preceding period?”, the computing power of the times limited its application.
A decade later, Sharpe introduced the single- index model [1963]. In essence, Sharpe’s model
re- placed the exact, but cumbersome, Markowitz formula for portfolio volatility with a
simplified approximation that assumed all the interrelationships among security returns could
be attributed to the fact that they all respond differentially to the pull of the
Single index. Sharpe represented his single index by the re- turns to the market itself, but
others (King [1966], for example) soon provided evidence that other common forces were
pulling security returns as well. King at the time noted industry-related factors, but since then
attention has shifted from aggregate stock market- or industry-related portfolios to more
generalized economic factors. In some models the factors are real (economic variables such
as unexpected changes in inflation, industrial production, and term and default premiums in
bond yields - see Chen, Roll, and Ross [1986]), while in others they are portfolios, derived
from factor analysis (Chen [1983]). The factor analytic portfolios allegedly mimic the
behaviour of the underlying economic variables actually responsible for the correlations
between security returns. Index models that initially were regarded as routes to a simplified
expression for portfolio volatility eventually became widely accepted
as ways to track targets such as the S&P 500. But times have changed since 1952. There have
been significant advances in computing hardware and in the algorithms to compute portfolio
volatility (Von Holhenbalken (19751). Analysts are now fully capable of obtaining
Markowitz solutions for several hundred securities at a time, which makes the relative
computational simplicity of index models less valuable. The latest advances in hardware and
software now make it possible to construct dedicated stock portfolios based on all the
information in the full covariance matrix of security returns. These portfolios are dedicated to
a mission of risk management such as hedging against inflation or against unexpected
changes in interest rates that may dramatically increase the present value of the liabilities of
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pension funds. Just as the Markowitz model provides the re- actively accurate answer to the
minimum volatility question posed above, it also provides the more accurate answer to the
question, “Which combination of securities would have achieved the greatest degree of
tracking power in the past?” While the relative predictive power of the Markowitz and index
models remains an open question.

Name of the Article: Optimal delegated portfolio management with background risk Author
Name: Alexandre M. Baptista *Department of Finance, School of Business, The George
Washington University, Funger Hall, Suite 501, 2201 G Street NW, Washington, DC 20052,
USA
Month and Year: Received 8 June 2007; accepted 26 July 2007
Abstract: Most investors delegate the management of a fraction of their wealth to portfolio
managers who are given the task of beating a benchmark. However, in an influential paper
[Roll, R., 1992. A mean/variance analysis of tracking error. Journal of Portfolio Management
18 shows that the objective functions commonly used by these managers lead to the selection
of portfolios that are suboptimal from the perspective of investors. In this paper, we provide

an explanation for the use of these objective functions based on the effect of background risk

on investors’ optimal portfolios. Our main contribution is to provide conditions under which
investors can optimally delegate the management of their wealth to portfolio managers. Most
investors delegate the management of a fraction of their wealth to portfolio managers who are
given the task of beating a benchmark. These managers commonly use objective functions
that lead to the selection of portfolios with minimum tracking error variance (TEV) for a
given expected gain over the benchmark (hereafter, ‘mean-TEV objective functions’).1
However, in an influential paper, Roll (1992) shows that
these portfolios are typically sub optimal from the perspective of investors.2 In particular,
managers tend to select portfolios that are overly risky for investors (see Jorion, 2002, 2003).
It is important to emphasize that Roll’s sub optimality result is obtained under the assumption
that investors face solely portfolio risk. In practice, however, investors often face additional
sources of risk such as those arising from labor income and real estate that might not be
insurable in financial markets. These sources of risk are commonl referred to as background
risk (see, e.g., Gollier, 2001).As Cornell and Roll (2005) point out, the literature has yet to
present an explanation for the use of mean-TEV objective functions by portfolio managers. In

this paper, we fill this gap in the literature by exploring the effect of background risk on the

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optimality of these objective functions from the perspective of investors. Our main
contribution is to provide conditions under which investors can optimally delegate the
management of their wealth to portfolio managers with mean-TEV objective functions.

Shaini & Mallikarjunappa (2016): The author believes that stock market is highly volatile and
it is up to the investors to decide how he could make use of the stock market to gain higher
returns. According to the author Beta would be very helpful in comparing the relative
systematic risk involved in different stocks. In practice investors use Beta to judge the
riskiness of each stock. An investor should remember risk is directly related to return and
hence he should ensure to keep risk associated proportional to returns. In general it is
believed that higher the risk, higher will be the returns, but seeking excessive risk may not be
advisable as it does not ensure excessive returns. At a particular level of return, security has
its own degree of risk. It is advised that investor should analyse the market on a continuous
basis, which in turn would help them pick the right stocks to invest.

Prathibha & Dinakar (2016): The author analysed the risks of 12 banks listed in bank nifty for
a period starting from 7th December 2015 till 8th February 2016. The author found from their
research that, all the stocks had negative returns during the study period except Yes bank and
Kotak Mahindra bank. The author founded that Yes Bank had given the highest return and
the lowest return was given by Punjab National Bank. It was also found that systematic risk
was highest for SBI and lowest for Yes bank. The author concluded that the Bank of India
and Syndicate Bank where less affected by market risk due the negative beta, while Punjab
National bank and Bank of Baroda had the highest market risk.

ASSUMPTIONS:

 All investors would like to earn the maximum rate of return that they can achieve
from their investments.
 All investors have the same expected single period investment horizon.
 All investors before making any investments have a common goal. This is the
avoidance of risk because Investors are risk-averse.
 Investors base their investment decisions on the expected return and standard
deviation of returns from a possible investment.
 Perfect markets are assumed (e.g. no taxes and no transaction costs)

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  The investor assumes that greater or larger the return that he achieves on his
investments, the higher the risk factor surrounds him. On the contrary when risks are
low the return can also be expected to be low.
 The investor can reduce his risk if he adds investments to his portfolio.
 An investor should be able to get higher return for each level of risk “by determining
the efficient set of securities”.

STOCK MARKET’S
A stock market or exchange is the center of a network of transactions where securities
Buyer’s meet sellers at a certain price. A stock market or exchange is not necessary a
physical facility and with the advancement of information technology are increasingly
rare those traders that exchange their stocks in the floor of a major stock exchange. The
main stock markets in INDIA are NATIONAL STOCK EXCHANGE (BSE) or
SENSEX and NATIONAL STOCK EXCHANGE (NSE) or NIFTY. The main stock
market in the United States is New York Stock Exchange (NYSE). In Europe,
examples of stock exchanges include the London Stock Exchange, the Paris Bourse,
and the Deutsche Bourse. In Asia, the main stock exchanges include the Tokyo Stock
Exchange, the Hong Kong Stock Exchange, and the National Stock Exchange. In Latin
America, there are such exchanges as the BOVESPA in Brazil and the MERVAL in
Argentina.

BSE SENSEX
The BSE SENSEX (National Stock Exchange Sensitive Index), also called the BSE 30
(NATIONAL STOCK EXCHANGE) or simply the SENSEX, is a free-float market
capitalization-weighted stock market index of 30 well-established and financially sound
companies listed on National Stock Exchange (BSE). The 30 component companies
which are some of the largest and most actively traded stocks, are representative of
various industrial sectors of the Indian economy. Published since January 1, 1986, the
SENSEX is regarded as the pulse of the domestic stock markets in India. The base
value of the SENSEX is taken as 100 on April 1, 1979, and its base year as 1978-79.
On 25 July 2001 BSE launched DOLLEX-30, a dollar-linked version of SENSEX. As
of 21 April 2011, the market capitalization of SENSEX was about 29,733 billion
(US$541 billion) (47.68% of market capitalization of BSE), while its free-float market
capitalization was 17,690 billion (US$286 billion).

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 Calculation
The BSE constantly reviews and modifies its composition to be sure it reflects current
market conditions. The index is calculated based on a free float capitalization method, a
variation of the market capitalization method. Instead of using a company's outstanding
shares it uses its float, or shares that are readily available for trading. The free-float
method, therefore, does not include restricted stocks, such as those held by promoters,
government and strategic investors. Initially, the index was calculated based on the
"full market capitalization method". However this was shifted to the free float method
with effect from September 1, 2003. Globally, the free float market capitalization is
regarded as the industry best practice.

As per free float capitalization methodology, the level of index at any point of time
reflects the free float market value of 30 component stocks relative to a base period.
The market capitalization of a company is determined by multiplying the price of its
stock by the number of shares issued by the company. This market capitalization is
multiplied by a free float factor to determine the free float market capitalization. Free
float factor is also referred as adjustment factor. Free float factor represents the
percentage of shares that are readily available for trading. The calculation of SENSEX
involves dividing the free float market capitalization of 30 companies in the index by a
number called index divisor. The divisor is the only link to original base period value of
the SENSEX. It keeps the index comparable over time and is the adjustment point for
all index adjustments arising out of corporate actions, replacement of scrip’s, etc.

The index has increased by over ten times from June 1990 to the present. Using
information from April 1979 onwards, the long-run rate of return on the BSE SENSEX
works out to be 18.6% per annum, which translates to roughly 9% per annum

INDIA STOCK MARKET (SENSEX)

Stocks in India had a negative performance during the last month. India Stock Market
(SENSEX), declined 456 points or 2.27 percent during the last 30 days. Historically,
from 1979 until 2013, India Stock Market (SENSEX) averaged 5563 Index points
reaching an all time high of 21005 Index points in November of 2010 and a record low
of 113 Index points in December of 1979. The SENSEX (BSE30) is a major stock

23
market index which tracks the performance of 30 major companies listed on the
National Stock Exchange. The companies are chosen based on the liquidity, trading
volume and industry representation. The SENSEX, is a free-float market capitalization-
weighted index. The Index has a base value of 100 as of 1978-79.
Here is a timeline on the rise of the SENSEX through Indian stock market
history:

a. 1000, July 25, 1990 - On July 25, 1990, the SENSEX touched the four-
digit figure for the first time and closed at 1,001 in the wake of a good
monsoon and excellent corporate results.

b. 2000, January 17, 1992 - On January 17, 1992, the SENSEX crossed the
2,000-mark and closed at 2,020 followed by the liberal economic policy
initiatives undertaken by the then finance minister and current Prime
Minister Dr Manmohan Singh.

c. 3000, February 29, 1992 - On February 29, 1992, the SENSEX surged
past the 3000 mark in the wake of the market-friendly Budget announced
by Manmohan Singh.

d. 4000, March 30, 1992 - On March 30, 1992, the SENSEX crossed the
4,000-mark and closed at 4,091 on the expectations of a liberal export-
import policy. It was then that the Harshad Mehta scam hit the markets
and SENSEX witnessed unabated selling.

e. 5000, October 11, 1999 - On October 8, 1999, the SENSEX crossed the
5,000-mark.

f. 6000, February 11, 2000 - On February 11, 2000, the information

technology boom helped the SENSEX to cross the 6,000-mark and hit and
all time high of 6,006.

24
g. 7000, June 21, 2005 - On June 20, 2005, the news of the settlement
between the Ambani brothers boosted investor sentiments and the scrip’s
of RIL, Reliance Energy, Reliance Capital and IPCL made huge gains.
This helped the SENSEX crossed 7,000 points for the first time.

h. 8000, September 8, 2005 - On September 8, 2005, the National Stock

Exchange's benchmark 30-share index – the SENSEX - crossed the 8000
level following brisk buying by foreign and domestic funds in early
trading.

i. 9000, December 9, 2005 - The SENSEX on November 28, 2005 crossed

9000 to touch 9000.32 points during mid-session at the National Stock
Exchange on the back of frantic buying spree by foreign institutional
investors and well supported by local operators as well as retail investors.

j. 10,000, February 7, 2006 - The SENSEX on February 6, 2006 touched

10,003 points during mid-session. The SENSEX finally closed above the
10,000-mark on February 7, 2006.

k. 11,000, March 27, 2006 - The SENSEX on March 21, 2006 crossed
11,000 and touched a peak of 11,001 points during mid-session at the
National Stock Exchange for the first time. However, it was on March 27,
2006 that the SENSEX first closed at over 11,000 points.

l. 12,000, April 20, 2006 - The SENSEX on April 20, 2006 crossed 12,000
and touched a peak of 12,004 points during mid-session at the National
Stock Exchange for the first time.

m. 13,000, October 30, 2006 - The SENSEX on October 30, 2006 crossed
13,000 for the first time. It touched a peak of 13,039.36 and finally closed
at 13,024.26.

25
n. 14000, December 5, 2006 - The SENSEX on December 5, 2006 crossed
14,000.

o. 17,000, July 6, 2007 - The SENSEX on July 6, 2007 crossed 17,000 mark.

p. 18,000, September 19, 2007 - The SENSEX on September 19, 2007

crossed the 18,000 mark.

q. 17,000, September 26, 2007 - The SENSEX on September 26, 2007

crossed the 17,000 mark for the first time.

r. 18,000, October 9, 2007 - The SENSEX on October 9, 2007 crossed the

18,000 mark for the first time.

s. 19,000, October 17, 2007 - The SENSEX on October 17, 2007 crossed
the 19,000 mark for the first time.

t. 20,000, October 29, 2007 - The SENSEX on October 29, 2007 crossed
the 20,000 mark for the first time.

u. 21,000, Jan 08, 2008 - The SENSEX on January 8, 2008 touched all time
peak of 21078 before closing at 20873.

v. November 5, 2010 - The SENSEX on November 5, 2010 closes at

20,893.6 with highest peak in two years.

w. January 18, 2013 - The SENSEX on January 18, 2013 closes at

20,039.04 with highest peak in two years.

x. February 28, 2014 – The SENSEX on February 28, 2014 closes at

21,120.12 which is the highest peak ever.

26
 Exploring the Volatility of Stock Markets: In

dian Experience
1. “Prashant Joshi and Kiran Pandya”
The main focus of this paper is to examine the nature of the volatility in the
Indian stock markets. Analysis of stock market for the evaluation of risk has
received lot of attention both from policy makers and researchers. The quality of
risk measures very largely depends on how well the econometric model captures
the behaviour of underlying asset. We employed ARCH and GARCH models to
study the behaviour of volatility. Our study shows that GARCH (1, 1) model
satisfactorily explains volatility clustering and its high persistence.
2. “Bhalla V.K.” (1997)

He reviewed the various factors influencing the equity price and price earnings ratio.
It is a opinion that equity prices are affected primarily by financial risk
considerations that, in turn, affect earnings and dividends. He also stated that market
risk in equity is much greater than in bonds, and it influences the price also. He
disclosed that many analysts follow price earnings (P/E) ratio to value equity, which
is equal to market price divided by earnings per share. He observed that inflationary
expectations and higher interest rates tend to reduce P/E ratios whereas growth
companies tend to have higher P/E ratios. He suggested that an investor should
examine the trend of P/E ratios over time for each company.

3.Pattabhi Ram.V.17 (1995)

He emphasized the need for doing fundamental analysis and doing Equity Research
(ER) before selecting shares for investment. He opined that the investor should look for
value with a margin of safety in relation to price. The margin of safety is the gap
between price and value. He revealed that the Indian stock market is an inefficient
market because of the absence of good communication network, rampant price rigging,
the absence of free and instantaneous flow of information, professional broking and so
on. He concluded that in such inefficient market, equity research will produce better
results as there will be frequent mismatch between price and value that provides

27
opportunities to the long-term value oriented investor. He added that in the Indian stock
market investment returns would improve only through quality equity research

2.2 Risk:
In finance, risk is the probability that an investment's actual return will be different than
expected. This includes the possibility of losing some or all of the original investment.
It is usually measured by calculating the standard deviation of the historical returns or
average returns of a specific investment.

In finance, risk has no one definition, but some theorists, notably Ron Dembo, have
defined quite general methods to assess risk as an expected after-the-fact level of regret.
Such methods have been uniquely successful in limiting interest rate risk in financial
markets. Financial markets are considered to be a proving ground for general methods
of risk assessment.

However, these methods are also hard to understand. The mathematical difficulties
interfere with other social goods such as disclosure, valuation and transparency. In
particular, it is often difficult to tell if such financial instruments are "hedging"
(purchasing/selling a financial instrument specifically to reduce or cancel out the risk in
another investment) or "gambling" (increasing measurable risk and exposing the
investor to catastrophic loss in pursuit of very high windfalls that increase expected
value).
As regret measures rarely reflect actual human risk-aversion, it is difficult to determine
if the outcomes of such transactions will be satisfactory. Risk seeking describes an
individual whose utility function's second derivative is positive. Such an individual
would willingly (actually pay a premium to) assume all risk in the economy and is
hence not likely to exist.
In financial markets, one may need to measure credit risk, information timing and
source risk, probability model risk, and legal risk if there are regulatory or civil actions
taken as a result of some "investor's regret".
"A fundamental idea in finance is the relationship between risk and return. The greater
the amount of risk that an investor is willing to take on, the greater the potential return.

28
The reason for this is that investors need to be compensated for taking on additional
risk."

"For example, a US Treasury bond is considered to be one of the safest investments

and, when compared to a corporate bond, provides a lower rate of return. The reason
for this is that a corporation is much more likely to go bankrupt than the U.S.
government. Because the risk of investing in a corporate bond is higher, investors are
offered a higher rate of return."

Risks can be classified as Systematic risks and Unsystematic risks.

Unsystematic Risks:
The Risk of price change due to the unique circumstances of a specific security, as
opposed to the overall market. This risk can be virtually eliminated from a portfolio
through diversification. These are risks that are unique to a firm or industry. Factors
such as management capability, consumer preferences, labor, etc. contribute to
unsystematic risks. Unsystematic risks are controllable by nature and can be
considerably reduced by sufficiently diversifying one's portfolio.

Systematic Risks:
Risk, which is common to an entire class of assets or liabilities. The value of
investments may decline over a given time period simply because of economic changes
or other events that impact large portions of the market. Asset allocation and
diversification can protect against systematic risk because different portions of the
market tend to underperformed at different times. Also called Market Risk.
These are risks associated with the economic, political, sociological and other macro-
level changes. They affect the entire market as a whole and cannot be controlled or
eliminated merely by diversifying one's portfolio.
The degree, to which different portfolios are affected by these systematic risks as
compared to the effect on the market as a whole, is different and is measured by Beta.
To put it differently, the systematic risks of various securities differ due to their
relationships with the market. The Beta factor describes the movement in a stock's or a
portfolio's return in relation to that of the market returns. For all practical purposes, the
market returns are measured by the returns on the index (Nifty, Mid-cap etc.), since the

29
index is a good reflector of the market.
A stock market index should capture the behavior of the overall equity market.
Movements of the index should represent the returns obtained by "typical" portfolios in
the country.

Diversifiable risk
Definition: The risk of price change due to the unique circumstances of a specific
security, as opposed to the overall market. This risk can be virtually eliminated from a
portfolio through diversification. Also called Unsystematic Risk.

Hedge
In finance, a hedge is an investment that is taken out specifically to reduce or
cancel out the risk in another investment. Hedging is a strategy designed to
minimize exposure to an unwanted business risk, while still allowing the business
to profit from an investment activity. Typically, a hedger might invest in a security
that he believes is under-priced relative to its "fair value" (for example a mortgage
loan that he is then making), and combine this with a short sale of a related security
or securities. Thus the hedger is indifferent to the movements of the market as a
whole, and is interested only in the performance of the 'under-priced' security
relative to the hedge. Holbrook Working, a pioneer in hedging theory, called this
strategy "speculation in the basis," where the basis is the difference between the
hedge's theoretical value and its actual value (or between spot and futures prices in
Working's time).

Some form of risk taking is inherent to any business activity. Some risks are considered
to be "natural" to specific businesses, such as the risk of oil prices increasing or
decreasing is natural to oil drilling and refining firms. Other forms of risk are not
wanted, but cannot be avoided without hedging. Someone who has a shop, for example,
expects to face natural risks such as the risk of competition, of poor or unpopular
products, and so on. The risk of the shopkeeper's inventory being destroyed by fire is
unwanted, however, and can be hedged via a fire insurance contract. Not all hedges are
financial instruments: a producer that exports to another country, for example, may
hedge its currency risk when selling by linking its expenses to the desired currency.

30
Banks and other financial institutions use hedging to control their asset-liability
mismatches, such as the maturity matches between long, fixed-rate loans and short-
term (implicitly variable-rate) deposits.

The principle that potential return rises with an increase in risk. Low levels of uncertainty
(low-risk) are associated with low potential returns, whereas high levels of uncertainty (high-
risk) are associated with high potential returns. According to the risk-return tradeoff, invested
money can render higher profits only if it is subject to the possibility of being lost.
Investors are risk averse; i.e., given the same expected return, they will choose the investment
for which that return is more certain. Therefore, investors demand a higher expected return for
riskier assets. Note that a higher expected return does not guarantee a higher realized return.
Because by definition returns on risky assets are uncertain, an investment may not earn its
expected return.
Although it show historical (realized) returns rather than expected (future) returns, they are
useful to demonstrate the relationship between risk and return. Note that the mean (average)
annual return increases as the dispersion of returns increases.
If inflation is considered, even money market securities have some risk. They may not achieve
the expected real (inflation-adjusted) return. Unexpected inflation may reduce the real return
below the expected return of the money market investment. Uncertainty in real returns can be
eliminated by investing in inflation-indexed securities, such as Treasury Inflation Protected
Securities (TIPS) and Series I Savings Bonds (I Bonds). In return for this reduction of
uncertainty, investors must accept lower expected returns. Even inflation-linked securities
have risks; e.g., TIPS have interest-rate risk, re-investment risk, and liquidity risk. No
investment is truly risk-free.

The objective of the Risk / Return Analysis is to give investors a concise summary of historic
asset class performance over investment periods of varying length. THE COVER
IMAGE The image on the front cover of the handout is intended to show what each of the
bars over-page represents. The line graph shows the performance of shares over each of the
721 twelve-month periods which may be observed using month-end data between 1 January
2008 and 31 December 2013. The bar to the right is a summary of the same performance data
used to draw the line graph. The bar highlights the best and worst twelve-month preiods; the
range within which 90% of returns fell; the percentage of returns which were positive; the
point of the median return; and the point of the most recent return. THE PERFORMANCE
31
 HISTORY OF THE ASSET CLASSES The main bar graph shows the range of returns
observed for the following four asset classes:
 International Shares
 Australian Shares
 Bonds
 Cash
Investment periods of 1-year, 3-years, 5-years, 10-years and 20-years are graphed. WHERE
INVESTORS ACHIEVED THE GREATEST GROWTH The area column graphs at the
bottom of the inside spread summarise how frequently each asset class outperformed the
others over investment periods ranging from one year to twenty-five years. The first of these
graphs compares Australian shares, bonds and cash since 1950. The second includes
international shares, but relies on data since 1970 only. Both the main bar graph, and the area
column graphs highlight the historical tendency for equity investments to outperform fixed
interest and cash over longer investment periods.

TYPES OF PORTFOLIO MANAGEMENT:

DISCRETIONARY PORTFOLIO MANAGEMENT SERVICE (DPMS):

In this type of service, the client parts with his money in favor of the manager, who in
return, handles all the paper work, makes all the decisions and gives a good return on the
investment and charges fees. In the Discretionary Portfolio Management Service, to maximize
the yield, almost all portfolio managers park the funds in the money market securities such as
overnight market, 18 days treasury bills and 90 days commercial bills. Normally, the return of
such investment varies from 14 to 18 percent, depending on the call money rates prevailing at
the time of investment.

2. NON-DISCRETIONARY PORTFOLIO MANAGEMENT SERVICE

(NDPMS):

The manager functions as a counselor, but the investor is free to accept or reject the
manager‘s advice; the paper work is also undertaken by manager for a service charge. The
manager concentrates on stock market instruments with a portfolio tailor-made to the risk
taking ability of the investor.
32
IMPORTANCE OF PORTFOLIO MANAGEMENT:
 Emergence of institutional investing on behalf of individuals. A number of financial
institutions, mutual funds and other agencies are undertaking the task of investing money
of small investors, on their behalf.

 Growth in the number and size of ingestible funds – a large part of household savings is
being directed towards financial assets.

 Increased market volatility – risk and return parameters of financial assets are
continuously changing because of frequent changes in government‘s industrial and fiscal
policies, economic uncertainty and instability.

 Greater use of computers for processing mass of data.

 Professionalization of the field and increasing use of analytical methods (e.g. quantitative
techniques) in the investment decision – making

 Larger direct and indirect costs of errors or shortfalls in meeting portfolio objectives –
increased competition and greater scrutiny by investors.

CRITERIA FOR PORTFOLIO DECISIONS:

 In portfolio management emphasis is put on identifying the collective importance of

all investor’s holdings. The emphasis shifts from individual assets selection to a more
balanced emphasis on diversification and risk-return interrelationships of individual
assets within the portfolio. Individual securities are important only to the extent they
affect the aggregate portfolio. In short, all decisions should focus on the impact which
the decision will have on the aggregate portfolio of all the assets held.

 Portfolio strategy should be molded to the unique needs and characteristics of the
portfolio‘s owner.

33
  Diversification across securities will reduce a portfolio‘s risk. If the risk and return
are lower than the desired level, leverages (borrowing) can be used to achieve the
desired level.
 Larger portfolio returns come only with larger portfolio risk. The most important
decision to make is the amount of risk which is acceptable.
 The risk associated with a security type depends on when the investment will be
liquidated. Risk is reduced by selecting securities with a payoff close to when the
portfolio is to be liquidated.
 Competition for abnormal returns is extensive, so one has to be careful in evaluating
the risk and return from securities. Imbalances do not last long and one has to act fast
to profit from exceptional opportunities.

QUALITIES OF PORTFOLIO MANAGER:

1. SOUND GENERAL KNOWLEDGE: Portfolio management is an exciting and challenging

job. He has to work in an extremely uncertain and confliction environment. In the stock
market every new piece of information affects the value of the securities of different
industries in a different way. He must be able to judge and predict the effects of the
information he gets. He must have sharp memory, alertness, fast intuition and self-
confidence to arrive at quick decisions.

2. ANALYTICAL ABILITY: He must have his own theory to arrive at the instrinsic value of the
security. An analysis of the security‘s values, company, etc. is s continuous job of the portfolio
manager. A good analyst makes a good financial consultant. The analyst can know the strengths,
weaknesses, opportunities of the economy, industry and the company.

3. MARKETING SKILLS: He must be good salesman. He has to convince the clients about the
particular security. He has to compete with the stock brokers in the stock market. In this context, the
marketing skills help him a lot.

4. EXPERIENCE: In the cyclical behavior of the stock market history is often repeated, therefore
the experience of the different phases helps to make rational decisions. The experience of the
different types of securities, clients, market trends, etc., makes a perfect professional manager.

PORTFOLIO BUILDING:

34
 Portfolio decisions for an individual investor are influenced by a wide variety of factors.
Individuals differ greatly in their circumstances and therefore, a financial programme well suited to
one individual may be inappropriate for another. Ideally, an individual‘s portfolio should be tailor-
made to fit one‘s individual needs.
Investor‘s Characteristics:
An analysis of an individual‘s investment situation requires a study of personal characteristics
such as age, health conditions, personal habits, family responsibilities, business or professional
situation, and tax status, all of which affect the investor‘s willingness to assume risk.

Stage in the Life Cycle:

One of the most important factors affecting the individual‘s investment objective is his stage
in the life cycle. A young person may put greater emphasis on growth and lesser emphasis on
liquidity. He can afford to wait for realization of capital gains as his time horizon is large.

Family responsibilities:
The investor‘s marital status and his responsibilities towards other members of the family can
have a large impact on his investment needs and goals.
Investor‘s experience:
The success of portfolio depends upon the investor‘s knowledge and experience in financial
matters. If an investor has an aptitude for financial affairs, he may wish to be more aggressive in his
investments.
Attitude towards Risk:
A person‘s psychological make-up and financial position dictate his ability to assume the risk.
Different kinds of securities have different kinds of risks. The higher the risk, the greater the
opportunity for higher gain or loss.

Liquidity Needs:
Liquidity needs vary considerably among individual investors. Investors with regular income
from other sources may not worry much about instantaneous liquidity, but individuals who depend
heavily upon investment for meeting their general or specific needs, must plan portfolio to match
their liquidity needs. Liquidity can be obtained in two ways:

1. By allocating an appropriate percentage of the portfolio to bank deposits, and

35
2. By requiring that bonds and equities purchased be highly marketable.

Tax considerations:
Since different individuals, depending upon their incomes, are subjected to different marginal
rates of taxes, tax considerations become most important factor in individual‘s portfolio strategy.
There are differing tax treatments for investment in various kinds of assets.

Time Horizon:
In investment planning, time horizon becomes an important consideration. It is highly variable
from individual to individual. Individuals in their young age have long time horizon for planning,
they can smooth out and absorb the ups and downs of risky combination. Individuals who are old
have smaller time horizon, they generally tend to avoid volatile portfolios.
Individual‘s Financial Objectives:
In the initial stages, the primary objective of an individual could be to accumulate wealth via
regular monthly savings and have an investment programmed to achieve long term capital gains.

Safety of Principal:
The protection of the rupee value of the investment is of prime importance to most investors.
The original investment can be recovered only if the security can be readily sold in the market
without much loss of value.

Assurance of Income:
`Different investors have different current income needs. If an individual is dependent of its
investment income for current consumption then income received now in the form of dividend and
interest payments become primary objective.

Investment Risk:
All investment decisions revolve around the trade-off between risk and return. All rational
investors want a substantial return from their investment. An ability to understand, measure and
properly manage investment risk is fundamental to any intelligent investor or a speculator.
Frequently, the risk associated with security investment is ignored and only the rewards are

36
emphasized. An investor who does not fully appreciate the risks in security investments will find it
difficult to obtain continuing positive results.

RISK AND EXPECTED RETURN:

There is a positive relationship between the amount of risk and the amount of expected return
i.e., the greater the risk, the larger the expected return and larger the chances of substantial loss. One
of the most difficult problems for an investor is to estimate the highest level of risk he is able to
assume.

 Risk is measured along the horizontal axis and increases from the left to right.

 Expected rate of return is measured on the vertical axis and rises from bottom to top.

 The line from 0 to R (f) is called the rate of return or risk less investments commonly
associated with the yield on government securities.

 The diagonal line form R (f) to E(r) illustrates the concept of expected rate of return
increasing as level of risk increases.

TYPES OF RISKS:

37
Risk consists of two components. They are
1. Systematic Risk
2. Un-systematic Risk

1. Systematic Risk:

Systematic risk is caused by factors external to the particular company and uncontrollable by
the company. The systematic risk affects the market as a whole. Factors affect the systematic risk are

 economic conditions

 political conditions

 sociological changes

The systematic risk is unavoidable. Systematic risk is further sub-divided into three types. They are

a) Market Risk

b) Interest Rate Risk

c) Purchasing Power Risk

a). Market Risk

One would notice that when the stock market surges up, most stocks post higher price. On
the other hand, when the market falls sharply, most common stocks will drop. It is not uncommon to
find stock prices falling from time to time while a company‘s earnings are rising and vice-versa. The
price of stock may fluctuate widely within a short time even though earnings remain unchanged or
relatively stable.

b). Interest Rate Risk:

Interest rate risk is the risk of loss of principal brought about the changes in the interest rate
paid on new securities currently being issued.

38
 c). Purchasing Power Risk:

The typical investor seeks an investment which will give him current income and / or capital
appreciation in addition to his original investment.

2. Un-systematic Risk:
Un-systematic risk is unique and peculiar to a firm or an industry. The nature and mode of raising
finance and paying back the loans, involve the risk element. Financial leverage of the companies that
is debt-equity portion of the companies differs from each other. All these factors affect the un-
systematic risk and contribute a portion in the total variability of the return.

 Managerial inefficiently

 Technological change in the production process

 Availability of raw materials

 Changes in the consumer preference

 Labor problems

The nature and magnitude of the above mentioned factors differ from industry to industry and
company to company. They have to be analyzed separately for each industry and firm. Un-systematic
risk can be broadly classified into:
a) Business Risk
b) Financial Risk

a. Business Risk:
Business risk is that portion of the unsystematic risk caused by the operating environment of the
business. Business risk arises from the inability of a firm to maintain its competitive edge and growth
or stability of the earnings. The volatility in stock prices due to factors intrinsic to the company itself
is known as Business risk. Business risk is concerned with the difference between revenue and
earnings before interest and tax. Business risk can be divided into.

i). Internal Business Risk

39
 Internal business risk is associated with the operational efficiency of the firm. The operational
efficiency differs from company to company. The efficiency of operation is reflected on the
company‘s achievement of its pre-set goals and the fulfillment of the promises to its investors.

ii).External Business Risk

External business risk is the result of operating conditions imposed on the firm by
circumstances beyond its control. The external environments in which it operates exert some
pressure on the firm. The external factors are social and regulatory factors, monetary and fiscal
policies of the government, business cycle and the general economic environment within which a
firm or an industry operates.
b. Financial Risk:
It refers to the variability of the income to the equity capital due to the debt capital. Financial risk in
a company is associated with the capital structure of the company. Capital structure of the company
consists of equity funds and borrowed funds.

PORTFOLIO ANALYSIS:

Various groups of securities when held together behave in a different manner and give
interest payments and dividends also, which are different to the analysis of individual securities. A
combination of securities held together will give a beneficial result if they are grouped in a manner to
secure higher return after taking into consideration the risk element.

There are two approaches in construction of the portfolio of securities. They are
 Traditional approach
 Modern approach
TRADITIONAL APPROACH:

Traditional approach was based on the fact that risk could be measured on each individual
security through the process of finding out the standard deviation and that security should be chosen
where the deviation was the lowest. Traditional approach believes that the market is inefficient and
the fundamental analyst can take advantage of the situation. Traditional approach is a comprehensive
financial plan for the individual. It takes into account the individual need such as housing, life
insurance and pension plans. Traditional approach basically deals with two major decisions. They are

40
  Determining the objectives of the portfolio
 Selection of securities to be included in the portfolio

MODERN APPROACH:
Modern approach theory was brought out by Markowitz and Sharpe. It is the combination of
securities to get the most efficient portfolio. Combination of securities can be made in many ways.
Markowitz developed the theory of diversification through scientific reasoning and method. Modern
portfolio theory believes in the maximization of return through a combination of securities. The
modern approach discusses the relationship between different securities and then draws inter-
relationships of risks between them. Markowitz gives more attention to the process of selecting the
portfolio. It does not deal with the individual needs.

MARKOWITZ MODEL:
Markowitz model is a theoretical framework for analysis of risk and return and their
relationships. He used statistical analysis for the measurement of risk and mathematical
programming for selection of assets in a portfolio in an efficient manner. Markowitz apporach
determines for the investor the efficient set of portfolio through three important variables i.e.
 Return
 Standard deviation
 Co-efficient of correlation

Markowitz model is also called as an “Full Covariance Model“. Through this model the
investor can find out the efficient set of portfolio by finding out the trade off between risk and return,
between the limits of zero and infinity. According to this theory, the effects of one security purchase
over the effects of the other security purchase are taken into consideration and then the results are
evaluated. Most people agree that holding two stocks is less risky than holding one stock. For
example, holding stocks from textile, banking and electronic companies is better than investing all
the money on the textile company‘s stock.
Markowitz had given up the single stock portfolio and introduced diversification. The single
stock portfolio would be preferable if the investor is perfectly certain that his expectation of highest
return would turn out to be real. In the world of uncertainty, most of the risk adverse investors
would like to join Markowitz rather than keeping a single stock, because diversification reduces the
risk.

41
ASSUMPTIONS:
 All investors would like to earn the maximum rate of return that they can achieve from their
investments.

 All investors have the same expected single period investment horizon.

 All investors before making any investments have a common goal. This is the avoidance of
risk because Investors are risk-averse.

 Investors base their investment decisions on the expected return and standard deviation of
returns from a possible investment.

 Perfect markets are assumed (e.g. no taxes and no transition costs)

 The investor assumes that greater or larger the return that he achieves on his investments, the
higher the risk factor surrounds him. On the contrary when risks are low the return can also
be expected to be low.

 The investor can reduce his risk if he adds investments to his portfolio.

 An investor should be able to get higher return for each level of risk “by determining the
efficient set of securities“.

 An individual seller or buyer cannot affect the price of a stock. This assumption is the basic
assumption of the perfectly competitive market.

 Investors make their decisions only on the basis of the expected returns, standard deviation
and covariance’s of all pairs of securities.

 Investors are assumed to have homogenous expectations during the decision-making period

42
  The investor can lend or borrow any amount of funds at the risk less rate of interest. The risk
less rate of interest is the rate of interest offered for the treasury bills or Government
securities.

 Investors are risk-averse, so when given a choice between two otherwise identical portfolios,
they will choose the one with the lower standard deviation.

 Individual assets are infinitely divisible, meaning that an investor can buy a fraction of a
share if he or she so desires.

 There is a risk free rate at which an investor may either lend (i.e. invest) money or borrow
money.

 There is no transaction cost i.e. no cost involved in buying and selling of stocks.

 There is no personal income tax. Hence, the investor is indifferent to the form of return either
capital gain or dividend.

THE EFFECT OF COMBINING TWO SECURITIES:

It is believed that holding two securities is less risky than by having only one investment in a
person‘s portfolio. When two stocks are taken on a portfolio and if they have negative correlation
then risk can be completely reduced because the gain on one can offset the loss on the other. This can
be shown with the help of following example:

INTER- ACTIVE RISK THROUGH COVARIANCE:

Covariance of the securities will help in finding out the inter-active risk. When the covariance
will be positive then the rates of return of securities move together either upwards or downwards.
Alternatively it can also be said that the inter-active risk is positive. Secondly, covariance will be
zero on two investments if the rates of return are independent.

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 Holding two securities may reduce the portfolio risk too. The portfolio risk can be calculated
with the help of the following formula:

CAPITAL ASSET PRICING MODEL (CAPM):

Markowitz, William Sharpe, John Lintner and Jan Mossin provided the basic structure of
Capital Asset Pricing Model. It is a model of linear general equilibrium return. In the CAPM theory,
the required rate return of an asset is having a linear relationship with asset‘s beta value i.e. un-
diversifiable or systematic risk (i.e. market related risk) because non market risk can be eliminated
by diversification and systematic risk measured by beta. Therefore, the relationship between an
assets return and its systematic risk can be expressed by the CAPM, which is also called the Security
Market Line.

R = Rf Xf+ Rm(1- Xf)

Rp = Portfolio return
Xf =The proportion of funds invested in risk free assets
1- Xf = The proportion of funds invested in risky assets
Rf = Risk free rate of return
Rm = Return on risky assets

Formula can be used to calculate the expected returns for different situations, like mixing risk
less assets with risky assets, investing only in the risky asset and mixing the borrowing with risky
assets.

THE CONCEPT:

According to CAPM, all investors hold only the market portfolio and risk less securities. The
market portfolio is a portfolio comprised of all stocks in the market. Each asset is held in proportion
to its market value to the total value of all risky assets.
For example, if wipro Industry share represents 17% of all risky assets, then the market
portfolio of the individual investor contains 17% of wipro Industry shares. At this stage, the investor
has the ability to borrow or lend any amount of money at the risk less rate of interest.
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 E.g.: assume that borrowing and lending rate to be 12.5% and the return from the risky assets
to be 20%. There is a trade off between the expected return and risk. If an investor invests in risk
free assets and risky assets, his risk may be less than what he invests in the risky asset alone. But if
he borrows to invest in risky assets, his risk would increase more than he invests his own money in
the risky assets. When he borrows to invest, we call it financial leverage. If he invests 50% in risk
free assets and 50% in risky assets, his expected return of the portfolio would be

Rp= Rf Xf+ Rm(1- Xf)

= (12.5 x 0.5) + 20 (1-0.5)
= 6.25 + 10
= 18.25%
if there is a zero investment in risk free asset and 100% in risky asset, the return is
Rp= Rf Xf+ Rm(1- Xf)
= 0 + 20%
= 20%

if -0.5 in risk free asset and 1.5 in risky asset, the return is

Rp= Rf Xf+ Rm(1- Xf)

= (12.5 x -0.5) + 20 (1.5)
= -6.25+ 30
= 23.75%

EVALUATION OF PORTFOLIO:

Portfolio manager evaluates his portfolio performance and identifies the sources of strengths
and weakness. The evaluation of the portfolio provides a feed back about the performance to evolve
better management strategy. Even though evaluation of portfolio performance is considered to be the

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last stage of investment process, it is a continuous process. There are number of situations in which
an evaluation becomes necessary and important.

i. Self Valuation: An individual may want to evaluate how well he has done. This is a part
of the process of refining his skills and improving his performance over a period of time.

ii. Evaluation of Managers: A mutual fund or similar organization might want to evaluate
its managers. A mutual fund may have several managers each running a separate fund or sub-
fund. It is often necessary to compare the performance of these managers.

iii. Evaluation of Mutual Funds: An investor may want to evaluate the various mutual
funds operating in the country to decide which, if any, of these should be chosen for
investment. A similar need arises in the case of individuals or organizations who engage
external agencies for portfolio advisory services.

iv. Evaluation of Groups: have different skills or access to different information.

Academics or researchers may want to evaluate the performance of a whole group of
investors and compare it with another group of investors who use different techniques or who

NEED FOR EVALUATION OF PORTFOLIO:

 We can try to evaluate every transaction. Whenever a security is brought or sold, we can
attempt to assess whether the decision was correct and profitable.

 We can try to evaluate the performance of a specific security in the portfolio to determine
whether it has been worthwhile to include it in our portfolio.

 We can try to evaluate the performance of portfolio as a whole during the period without
examining the performance of individual securities within the portfolio.

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PORTFOLIO REVISION:

The portfolio which is once selected has to be continuously reviewed over a period of time
and then revised depending on the objectives of the investor. The care taken in construction of
portfolio should be extended to the review and revision of the portfolio. Fluctuations that occur in the
equity prices cause substantial gain or loss to the investors.

The investor should have competence and skill in the revision of the portfolio. The portfolio
management process needs frequent changes in the composition of stocks and bonds. In securities,
the type of securities to be held should be revised according to the portfolio policy.

An investor purchases stock according to his objectives and return risk framework. The prices
of stock that he purchases fluctuate, each stock having its own cycle of fluctuations. These price
fluctuations may be related to economic activity in a country or due to other changed circumstances
in the market.

If an investor is able to forecast these changes by developing a framework for the future
through careful analysis of the behavior and movement of stock prices is in a position to make higher
profit than if he was to simply buy securities and hold them through the process of diversification.
Mechanical methods are adopted to earn better profit through proper timing. The investor uses
formula plans to help him in making decisions for the future by exploiting the fluctuations in prices.

FORMULA PLANS:
The formula plans provide the basic rules and regulations for the purchase and sale of
securities. The amount to be spent on the different types of securities is fixed. The amount may be
fixed either in constant or variable ratio. This depends on the investor‘s attitude towards risk and
return. The commonly used formula plans are

i. Average Rupee Plan

ii. Constant Rupee Plan
iii. Constant Ratio Plan
iv. Variable Ratio Plan
v.

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ADVANTAGES:
 Basic rules and regulations for the purchase and sale of securities are provided.
 The rules and regulations are rigid and help to overcome human emotion.
 The investor can earn higher profits by adopting the plans.
 A course of action is formulated according to the investor‘s objectives
 It controls the buying and selling of securities by the investor.

DISADVANTAGES:
 The formula plan does not help the selection of the security. The selection of the security has
to be done either on the basis of the fundamental or technical analysis.
 It is strict and not flexible with the inherent problem of adjustment.
 The formula plans should be applied for long periods, otherwise the transaction cost may be
high.
 Even if the investor adopts the formula plan, he needs forecasting. Market forecasting helps
him to identify the best stocks.

1. OVERVIEW : The main purpose of studying is to examine the policy

adopted for decision making in the area of Portfolio management in General Insurance
Company with a special focus on Portfolio.
2. SCOPE : In the presence study cover through
examination of procedures of decision
making portfolio management
environment, selection of securities
Weights of different securities and
Earning of Portfolio.

3. FINDINGS : The trend of Stock Exchange, securities in

India has shown increasing trend on an
Average the investments in such securities
increased by 173.47% yearly over the study
period. How ever the trend of investment in
stock exchange, securities both in India and
Outside India has shown investment incase

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 Is 174.77% per year over the study period.

PORTFOLIO MANAGEMENT USING CAPM

1. OVERVIEW : Portfolio analysis to measure this actual risk
And return of securities and to calculate the
Expected returns of securities using
Security market line to compare the expected
Return with actual return to assist investor in
Making rational investment decision to which
Security to buy or sell using security market
Line which is to suggested the best portfolio
Mix .
2. SCOPE : The scope of the study is limited to this use of
Security market line as a tool of selecting
Security and advising the investors about the
Best portfolio mix.
3. FINDINGS : There is a significant difference between the
Expected returns and actual returns. The next
Step is to identify the securities which are under
Value when their expected returns is more than
Actual returns, it can be observed undervalued
Securities like Cipla, Dr. Reddy Labs,
wipro etc., wipro is linear since the
Weights (X) are the variables

INVESTMENT
Investment may be defined as an activity that commits funds in any financial form in the
present with an expectation of receiving additional return in the future. The expectations bring with it
a probability that the quantum of return may vary from a minimum to a maximum. This possibility of
variation in the actual return is known as investment risk. Thus every investment involves a return
and risk.

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 Investment is an activity that is undertaken by those who have savings. Savings can be
defined as the excess of income over expenditure. An investor earns/expects to earn additional
monetary value from the mode of investment that could be in the form of financial assets.

 The three important characteristics of any financial asset are:

Return-the potential return possible from an asset.
 Risk-the variability in returns of the asset form the chances of its value going down/up.
 Liquidity-the ease with which an asset can be converted into cash.
Investors tend to look at these three characteristics while deciding on their individual
preference pattern of investments. Each financial asset will have a certain level of each of these
characteristics.

Investment avenues
There are a large number of investment avenues for savers in India. Some of them are
marketable and liquid, while others are non-marketable. Some of them are highly risky while some
others are almost risk less.
Investment avenues can be broadly categorized under the following head.

1. Corporate securities
2. Equity shares.
3. Preference shares.
4. Debentures/Bonds.
5. Derivatives.
6. Others.

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 Corporate Securities

Joint stock companies in the private sector issue corporate securities. These include equity
shares, preference shares, and debentures. Equity shares have variable dividend and hence belong to
the high risk-high return category; preference shares and debentures have fixed returns with lower
risk.The classification of corporate securities that can be chosen as investment avenues can be
depicted as shown below:

Equity Preference Bonds Warrants Derivatives

Shares shares

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