Security Analysis and Portfolio Management

Dr.Suyash Bhatt

Topics for discussion

y Risk Management y Portfolio Risk Return y Capital Asset Portfolio Management
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Risk Management

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Risk in a Traditional Sense

y Risk in holding securities is generally associated

with possibility that realized returns will be less than the returns that were expected. y The source of such disappointment is the failure of dividends (interest) and/or the securitys price to materialize as expected.

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Types of Risk
1.

Systematic Risk
a. b. c. Market Risk Interest-Rate Risk Purchasing Power Risk Business Risk Financial Risk

2.

Unsystematic
a. b.

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Systematic Risk
y Systematic risk reflects market-wide factors such as the

country's rate of economic growth, corporate tax rates, interest rates etc. Since these market-wide factors generally cause returns to move in the same direction they cannot cancel out. y Therefore, systematic risk remains present in all portfolios. Some investments will be more sensitive to market factors than others and will therefore have a higher systematic risk.

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Market Risk
y

Market risk is usually touched off by a reaction to real events, but the emotional instability of investors acting collectively leads to a snow balling over reaction. Likewise, sticks in a particular industry group can be hard hit when the industry goes out of fashion.

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Interest-Rate Risk
y Higher interest rates, for example, may lead to lower

prices because of a diminished demand for equities by speculators who use margin. y As interest rates advance, firms with heavy doses of borrowed capital find that more of their income goes toward paying interest on borrowed money. This may lead to lower earnings, dividends, and share prices. y Advancing interest rates can bring higher earnings to lending institutions whose principal revenue sources is interest received on loans
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Purchasing Power Risk

y Purchasing-power risk is the uncertainty the purchasing

power of the amounts to be received. In more everyday terms, purchasing-power risk refers to the impact of inflation or deflation on an investment. y If we think of investment as the postponement of consumption, we can see that when a person purchases a stock, he has foregone the opportunity to buy some good or service for as long as he owns the stock. If, during the holding period, good or services rise, the investor actually loses purchasing power.

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Unsystematic risk
y Unsystematic risk is the portion of total risk that is

unique or peculiar to a firm or an industry, above and beyond that affecting securities markets in general. y Factors such as management capability, consumer preferences, and labor strikes can cause unsystematic variability of returns for a companys stock. y Because these factors affect one industry and/or one firm, they must be examined separately for each company.

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Business Risk
y Business risk can be divided into two broad

categories: external and internal.

y Internal business risk is largely associated with the

efficiency with which a firm conducts its operations with in the broader operating environment imposed upon it. y External business risk is the result of operating conditions imposes upon the firm by circumstances beyond its control.

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Financial Risk
y Financial risk is associated with the way in which a company

finances its activities. We usually gauge financial risk by looking at the capital structure of a firm.

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Financial Risk
y A firm with no debt financing has no financial risk. y Engaging in debt financing, the firm changes the

characteristic of the earnings stream available to the common-stock holders. y Specifically, the reliance on debt financing, called financial leverage, has three important effects on common-stock holders. y Debt financing
(1) increases the variability of their returns, (2) affects their expectations concerning their returns, and (3) increases their risk of being ruined.

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Portfolio Risk - Return

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Return of Single Asset

The typical object of investment is to make current income from

investments in the form of dividends and interest income. The investments should earn reasonable and expected rate of return on investments. Certain investments like bank deposits, public deposits, debentures, bonds etc. will carry a fixed rate of return payable periodically. In case of investments in shares of companies, the periodical payments in the form of dividends are not assured, but it may ensure higher returns than fixed income investments. But the investments in equity shares of companies carry higher risk than fixed income instruments, Another form of return is in the form of capital appreciation. This element of return is the difference between the purchase price and the price at which the asset can be sold, it can be a capital gain or capital loss arising due to change in the price of the investment.

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Risk of Single Asset

The concept of risk is more difficult to quantify. Statistically we

can express risk in terms of standard deviation of return. For example, in case of gilt edged security or government bonds, the risk is nil since the return does not vary - it is fixed. But strictly speaking if we consider inflation and calculate real rate of return (inflation adjusted) we find that even government bonds have some amount of risk since the rate of inflation may vary. Return from unsecured fixed deposits appear to have zero variability and hence zero risk. But there is a risk of default of interest as well as the principal. In such case the rate of return can be negative. Hence, this investment has high risk though apparently it carries zero risk. For other investments like shares, business etc., where the rate of return is not fixed, there may be a schedule of return with associated probability for each rate of return.
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Risk of Single Asset

The mean of the probable returns gives the expected rate of

return and the standard deviation or variance which is square of standard deviation measures risk. Higher the range of the probable return, higher the standard deviation and hence higher the risk. A risk averse investor will look for return where the range is low. Hence, low standard deviation means low risk. The problem in portfolio management is to minimise the standard deviation without sacrificing expected rate of return. This is possible by diversification. Risk is measured in terms of variability of returns.
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Problem 1
y The rate of return of equity shares of Hill Top Ltd. for past six

years are given below:

Year Rate of Retur n (%) 2000 12 2001 18 2002 -6 2003 20 2004 22 2006 24

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y Calculation of Average Rate of Return

R ! 12  18  6  20  22  24 ! 15% R!
N 6

W2 !

( R  R) 2 N

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Year

Rate of Return (%)

(R R)

(R R)2

2000 2001 2002 2003 2004 2005

12 18 -6 20 22 24

-3 3 -21 5 7 9

9 9 441 25 49 81

W ! W 2 ! Variance
W ! 102.33 ! 10.12%
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Return of Portfolio (Two Assets)

(R

) ! WA ( RA )  WB ( RB )

Where (Rp) = Expected return from a portfolio of two securities WA = Proportion of funds invested in Security A WB = Proportion of funds invested in Security B RA = Expected return of Security A RB = Expected return of Security B
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Risk of Portfolio (Two Assets)

The risk of a security is measured in terms of variance or

standard deviation of its returns. The portfolio risk is not simply a measure of its weighted average risk. The securities consisting in a portfolio are associated with each other. The portfolio risk also considers the covariance between the returns of the investment, covariance of two securities is a measure of their co-movement, it expresses the degree to which the securities vary together.
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Risk of Portfolio (Two Assets)

W p ! WA W A  WB W B  2WAWB V ABW AW B
Where W A= Standard deviation of portfolio consisting security A WA= Proportion of funds invested in Security A W B= Standard deviation of returns of security B WB= Proportion of funds invested in Security A V AB = Correlation coefficient between returns of Security A and Security B The Correlation coefficient ( ) can be calculated as follows :

V AB
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Cov AB ! W AW B

Capital Asset Pricing Model

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Capital Asset Pricing Model(CAPM)

y In finance, the capital asset pricing model (CAPM) is

used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk. y The model takes into account the asset's sensitivity to nondiversifiable risk (also known as systematic risk), often represented by the quantity beta ( ) in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset.
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Capital Asset Pricing Model[contd]

y The model was introduced by Jack Treynor (1961,

1962),William Sharpe(1964), John Lintner (1965) and Jan Mossin (1966) independently, building on the earlier work of Harry Markowitz on diversification and modern portfolio theory. y Sharpe, Markowitz and Merton Miller jointly received the Nobel Memorial Prize in Economics for this contribution to the field of financial economics.

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Capital Asset Pricing Model

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Capital Asset Pricing Model Formula

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Capital Asset Pricing Model Analogy

y The CAPM contends that shares co-move with the market. If

the market moves by 1% and a share has a beta of two, then the return on the share would move by 2%. The beta indicates the sensitivity of the return on shares with the return on the market. Some companies activities are more sensitive to changes in the market - eg luxury car manufacturers - have high betas, while those relating to goods and services likely to be in demand irrespective of the economic cycle - eg food manufacturers - have lower betas. The beta value of 1.0 is the benchmark against which all share betas are measured.
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Measure of Beta
y Beta > 1 - aggressive shares

These shares tend to go up faster then the market in a rising (bull) market and fall more than the market in a declining (bear) market. y Beta < 1 - defensive shares These shares will generally experience smaller than average gains in a rising market and smaller than average falls in a declining market. y Beta = 1 - neutral shares These shares are expected to follow the market.
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Problem:
Oriel plc is considering investing in one of two short-term portfolios of four short-term financial investments. The correlation between the returns of the individual investments is believed to be negligible (zero/independent/no correlation). See and the risk free rate 5%. Portfolio 1 and Portfolio 2. The market return is estimated to be 15%, Required: y Estimate the risk and return of the two portfolios using the principles of both portfolio theory and CAPM and decide which one should be selected. y How would you alter your calculations for the summary table if you were told: The correlation between the returns of the individual investments is perfectly positively correlated'

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y The beta value of a share is normally between 0 and 2.5. A

risk-free investment (a treasury bill) has a beta = 0 (no risk). The most risky shares like some of the more questionable penny share investments would have a beta value closer to 2.5.

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Portfolio 1
Investment Amounts invested million 10 40 30 20 Expected return 20% 22% 24% 26% Total risk Beta

a b c D

8 10 11 9

0.7 1.2 1.3 1.4

Portfolio 2
Investment Amounts invested million 20 40 20 DR.SUYASH20 BHATT Expected return 18% 20% 22% 16% Total risk Beta

a b c 33 d

7 9 12 13

0.8 1.1 1.2 1.4

Portfolio 1 Solution
Investment a b c d Investment weightings .1 .4 .3 .2 Expected return (%) 20 22 24 26 Portfolio expected return (%) 2.00 8.80 7.20 5.20 23.20 The required return: 5 + (15 - 5) 1.22 = 17.20% Beta 0.7 1.2 1.3 1.4 Portfolio beta .07 .48 .39 .28 1.22

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Portfolio 2 Solution
Investment a b c d Investment weightings .2 .4 .2 .2 Expected return (%) 18 20 22 16 Portfolio expected return (%) 3.60 8.00 4.40 3.20 19.20 The required return: 5 + (15 - 5) 1.12 = 16.20% Beta 0.8 1.1 1.2 1.4 Portfolio beta .16 .44 .24 .28 1.12

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Alpha table
Expected returns Portfolio 1 Portfolio 2 23.20% 19.20% Required returns 17.20% 16.20% Alpha values 6.00% 3.00%

Portfolio 1 is chosen because it has the largest positive alpha.

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Thank You

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