Module I

MARKET EFFICIENCY

Portfolio Management

Portfolio Combinations of securities in which an investors

investments are invested

Efficient Management of investments in various Securities of an

investor is portfolio management

It involves time to time choosing and revising portfolio of securities in

order to optimize the return

Objectives of Portfolio Management

Security of Principal Investment

Consistency of Returns

Capital Growth

Liquidity & Marketability

Diversification of Portfolio

Favorable Tax Status

Principles of Portfolio Management

Emphasis on returns from Collective holdings of the investor

Should Cater to the needs of the investors like tax benefits, tax
benefits, etc.

High Risk high Returns Should Balance the Risk & Expected Return of
the Investor

Liquidation of Portfolio & Liquidation of Securities in it should be at the

same time

One should act fast to take advantage of the available opportunities &
reduce the impact of the adverse situations pertaining to the
securities held

Scope of Portfolio Management

Identification of Investors Requirement

Formulation of Investment Policy Strategy Expected Return, Risk

Tolerance, Liquidity Requirement, etc.

Execution of Strategy

Monitoring of Portfolio

Efficient Capital Market

An efficient capital market is a market that is efficient in processing

information.

In other words, the market quickly and correctly adjusts to new

information.

In an information of efficient market, the prices of securities observed

at any time are based on correct evaluation of all information
available at that time.

Therefore, in an efficient market, prices immediately and fully reflect

available information.

Definition

"In an efficient market, competition among the many intelligent

participants leads to a situation where, at any point in time, actual
prices of individual securities already reflect the effects of information
based both on events that have already occurred and on events
which, as of now, the market expects to take place in the future. In
other words, in an efficient market at any point in time the actual
price of a security will be a good estimate of its intrinsic value."
- Professor Eugene Fama,

The Efficient Markets Hypothesis

The Efficient Markets Hypothesis (EMH) is made up of three

progressively stronger forms:

Weak Form

Semi-strong Form

Strong Form

The EMH Graphically

All historical prices and returns

In this diagram, the circles

represent
the
amount
of
information that each form of the
EMH includes.

Note that the weak form covers

the least amount of information,
and the strong form covers all
information.

Also note that each successive

form includes the previous ones.
All information, public and private

Strong Form
Semi-Strong
Weak Form

All public information

The Weak Form

The weak form of the EMH says that past prices, volume, and other market
statistics provide no information that can be used to predict future prices.
If stock price changes are random, then past prices cannot be used to
forecast future prices.
Price changes should be random because it is information that drives
these changes, and information arrives randomly.
Prices should change very quickly and to the correct level when new
information arrives (see next slide).
This form of the EMH, if correct, repudiates technical analysis.
Most research supports the notion that the markets are weak form
efficient.

The Semi-strong Form

The semi-strong form says that prices fully reflect all

publicly available information and expectations about the
future.
This suggests that prices adjust very rapidly to new
information, and that old information cannot be used to
earn superior returns.
The semi-strong form, if correct, repudiates fundamental
analysis.
Most studies find that the markets are reasonably efficient
in this sense, but the evidence is somewhat mixed.

The Strong Form

The strong form says that prices fully reflect all information, whether
publicly available or not.

Even the knowledge of material, non-public information cannot be

used to earn superior results.

Most studies have found that the markets are not efficient in this
sense.

Summary of Tests of the EMH

Weak form is supported, so technical analysis cannot consistently

outperform the market.

Semi-strong form is mostly supported , so fundamental analysis cannot

consistently outperform the market.

Strong form is generally not supported. If you have secret (insider)

information, you CAN use it to earn excess returns on a consistent basis.

Ultimately, most believe that the market is very efficient, though not
perfectly efficient. It is unlikely that any system of analysis could
consistently and significantly beat the market (adjusted for costs and risk)
over the long run.

http://
thismatter.com/money/investments/random-walk-efficient-market-hypoth
eses.htm

Diversification

Spreading an investment across a number of assets will eliminate

some, but not all, of the risk

Diversification and Unsystematic Risk - When securities are combined

into portfolios, their unique or unsystematic risks tend to cancel out,
leaving only the variability that affects all securities to some degree.
Large portfolios have little or no unsystematic risk.

Diversification and Systematic Risk -

Markowitz Portfolio Theory

This approach included portfolio formation by considering the expected rate of return
and risk of individual stocks and, crucially, their interrelationship as measured by
correlation.

Prior to this investors would examine investments individually, build up portfolios of

attractive stocks, and not consider how they related to each other.

The diversification plays a very important role in the modern portfolio theory.

Markowitz approach is viewed as a single period approach: at the beginning of the

period the investor must make a decision in what particular securities to invest and
hold these securities until the end of the period. Because a portfolio is a collection of
securities, this decision is equivalent to selecting an optimal portfolio from a set of
possible portfolios.

Thus Markowitz portfolio theory is the problem of optimal portfolio selection.

Markowitz Portfolio Theory

The method used in selecting the most desirable portfolio involves the
use of indifference curves.

Indifference curves represent an investors preferences for risk and

return. These curves should be drawn, putting the investment return
on the vertical axis and the risk on the horizontal axis.

http://thismatter.com/money/investments/single-index-model.htm

http://thismatter.com/money/investments/modern-portfolio-theory.htm

Capital Allocation Between a RiskFree Asset and a Risky Asset

Investors want to earn the highest return possible for a level of risk that
they are willing to take. So how does an investor allocate her capital to
maximize her investment utility the risk-return profile that yields the
greatest satisfaction? The simplest way to examine this is to consider a
portfolio consisting of 2 assets: a risk-free asset that has a low rate of return
but no risk, and a risky asset that has a higher expected return for a higher
risk. Investment risk is measured by the standard deviation of investment
returnsthe greater the standard deviation, the greater the risk. By varying
the relative proportions of the 2 assets, an investor can earn a risk-free
return by investing all of her money in the risk-free asset, or she can
potentially earn the maximum return by investing entirely in the risky asset,
or she can select a risk-return trade-off that is anywhere between these 2
extremes by selecting varying proportions of the 2 assets.

Capital Allocation Line (CAL)

http://thismatter.com/money/investments/capital-allocation.htm

Asset allocationistheapportionmentoffundsamongdifferent
typesofassetswithdifferentrangesofexpectedreturnsand
risk.Capital allocation,ontheotherhand,istheapportionmentof
fundsbetweenrisk-freeinvestments,suchasT-bills,andriskyassets,
suchasstocks.Thesimplestcaseofcapitalallocationistheallocation
offundsbetweenariskyassetandarisk-freeasset.Therisk-return
profileofthis2-assetportfolioisdeterminedbytheproportionofthe
riskyassettotherisk-freeasset.Ifthisportfolioconsistsofarisky
assetwithaproportionofy,thentheproportionoftherisk-freeasset
mustbe1 y.

Portfolio Return = y Risky Asset Return + (1 y) Risk-free

Return

Capital Allocation Line (CAL)

Onewaytoadjusttheriskinessofaportfolioisbyvaryingthe
proportionoftherisk-freeassetandtheriskyasset.Theinvestment
opportunity setisthesetofallcombinationsoftheriskyandriskfreeassets,whichgraphsasalinewhenplottedasreturnagainst
risk,asmeasuredbythestandarddeviation.Thelinebeginsatthe
interceptwiththeminimumreturnandnoriskoftherisk-freeasset,
whentheentireportfolioisinvestedintherisk-freeasset,tothe
maximumreturnandriskwhentheentireportfolioisinvestedinthe
riskyasset.Hence,thiscapital allocation line(CAL)isthegraph
ofallpossiblecombinationsoftherisk-freeassetandtheriskyasset.

Capital Allocation Line (CAL)

The slope of the capital allocation line is equal to the incremental return of the portfolio
to the incremental increase in risk. Hence, the slope of the capital allocation line is
called thereward-to-variability ratiobecause the expected return increases
continually with the increase in risk as measured by the standard deviation.

Slope of
CAL

Reward-toVariability Ratio

Portfolio Return Risk-Free Return

Standard Deviation of Portfolio

In the graph below, the capital allocation line (CAL) is plotted with the assumptions that
the risk-free rate has a 4% return and zero standard deviation, and the risky asset has
an expected return of 12% and a standard deviation of 15%. Note that the intercept of
the CAL is at 4%, which is the risk-free rate. This capital allocation line is the
investment opportunity set of all possible combinations of the risk-free and risky asset.

Capital Asset Pricing Model (CAPM)

Systematic risk(akamarket risk,undiversifiable risk,systemic risk)

is risk that affects all investments or classes of investments. Most
systematic risk is either economic or politicalinflationis the most
significant systematic risk because it lowers the real return of all
investments. Such risk cannot be diversified by investing in different classes
of assets.Diversifiable risk(akaunsystematic risk) affects specific
companies, because of such factors as bad management, lawsuits, and
labor trouble. Diversifiable risk can be lowered by investing in different
companies in different sectors or by investing in different asset classes, such
as stocks and bonds, but can only be minimized by investing in assets that
have a negative correlation coefficient, where the lows of some assets are
offset by the highs of other assets. Thetotal riskof any investment is the
sum of systematic risk + asset-specific risks.

Beta: A Measure of Specific

Systematic Risk

Although systematic risk affects allinvestment returns, some assets are more
sensitive to systematic risk than others, even those in the same asset class,
such as the stocks of different companies. If a particular stock, for instance, has
greater volatility due to systematic risk than the general market, then it would
be prudent for an investor to demand a greater return from that stock than
themarket return, which is the return of the market as a whole, such as the
stock market, or a subclass of a market, such as the NASDAQ or the S&P 500
stock index.

Thebetaof an asset, such as a stock, measures the market risk of that

particular asset as compared to the rest of the market hence, it also
measures volatility of the asset compared to the general market. The beta is
calculated by comparing the historical return of an asset compared to the
market return using statistical techniques to calculate their covariance

Beta: A Measure of Specific

Systematic Risk

The beta of the S&P 500 stock index market is considered 1. Most stocks
have apositive beta, which means that most stocks move in the same
direction as the general market. If the beta is greater than 1, then the stock
moves more than the market does in the same direction. For instance, if the
stock market increases in value by 1%, then a stock with a beta of 2
willoftenincrease by 2%. Likewise, if the market return decreases by 1%,
then a stock with a beta of 2 will decrease by 2%. Remember, however, that
since beta is a statistical calculation, the relationship is not fixed. If a stock
has a beta of 0.5, then it will increase by % for each 1% increase in the
market return. Hence, a stock with a beta of greater than 1 is riskier than the
general market, but potentially more profitable; a beta of less than 1 is
generally less risky than the general market, and gains will also probably be
less than market gains. Most stocks have betas than range from 0.5 1.75.

Beta: A Measure of Specific

Systematic Risk

Some stocks have anegative betabecause they have a negative

correlation to the general marketthey move in the opposite direction
to the general market. For instance, a stock with a beta of -1
willdecreasein value by 1% for eachincreaseof 1% in the general
stock market, and vice versa.

Calculating the Required Return

Using the CAPM

If therisk-free rate of a Treasury bill is 4%, and thereturn of the stock

market has averaged about 12%, what is the required return of a stock that
has a beta of1.4?

By using the CAPM formula, shown above, we find that:

Required Return=4%+ [1.4 (12%-4%)] =4%+1.4 8% =4%+

11.2% =15.2%

So if this stock only returned 13% in the past few years, then it has a greater
risk than is justified by its return compared to the general market.

http://thismatter.com/money/investments/capital-asset-pricing-model.htm

Arbitrage Pricing Theory (APT)

The fundamental foundation for thearbitrage pricing theory(APT)

is thelaw of one price, which states that 2 identical items will sell
for the same price, for if they do not, then a riskless profit could be
made byarbitragebuying the item in the cheaper market then
selling it in the more expensive market.

This principle also applies to financial instruments, such as stocks and

bonds.

For instance, if Microsoft stock is selling for $30 on one exchange, but
$30.25
on
another
exchange,
then
anarbitrageurcould
simultaneously buy the stock on the cheaper exchange and sell it
short on the more expensive exchange for a riskless profit.

Arbitrage Pricing Theory (APT)

The arbitrage is done simultaneously because the price discrepancy

must be taken advantage of immediately; otherwise it will probably
disappear by the time of settlement.

The arbitrageur would continue doing this until the price discrepancy
disappeared, since buying on the cheaper exchange would increase
thedemand, and therefore the price, on that exchange, while the
short selling on the more expensive exchange would increasesupply,
thereby reducing its price.

http://thismatter.com/money/investments/arbitrage-pricing-theory.htm