Short Notes

1) Discount Rate in DCF

Depending upon the context, the discount rate has two different
definitions and usages. First, the discount rate refers to the interest
rate charged to the commercial banks and other financial institutions
for the loans they take from the Federal Reserve Bank through the
discount window loan process, and second, the discount rate refers
to the interest rate used in discounted cash flow (DCF) analysis to
determine the present value of future cash flows.
The formula to calculate the value of future cash flows is:

...where Ci is the cash flow in year i, N is the total number of years

the cash flows will be generated (typically taken out to infinity),
and r is the discount rate. There are two things you need to perform
this calculation:
1) The cash flows for all future years. Obviously, this is a guess, but it
can be based on previous performance. These should be
conservative estimates and are difficult to make for a company that
has a short operating history or erratic cash flows.
2) The discount rate. This is the rate at which you discount future
cash flows.

The term discount rate can refer to either the interest rate that the
Federal Reserve charges banks for short term loans or the rate used
to discount future cash flows in discounted cash flow (DCF) analysis.
In a banking context, the discount lending is a key tool of monetary
policy and part of the Fed's function as lender-of-last-resort.
In DCF, the discount rate expresses the time value of money and can
make the difference between whether an investment project is
financially viable or not.
The same term, discount rate, is also used in discounted cash flow
analysis. DCF is a commonly followed valuation method used to
estimate the value of an investment based on its expected future
cash flows. Based on the concept of time value of money, the DCF
analysis helps assess the viability of a project or an investment by
calculating the present value of expected future cash flows using
a discount rate.
In simple terms, if a project needs a certain investment now (as well
as in future months) and predictions are available about the future
returns it will generate, then - using the discount rate - it is possible
to calculate the current value of all such cash flows. If the net
present value is positive, the project is considered viable. Otherwise,
it is considered financially unfeasible.
In this context of DCF analysis, the discount rate refers to the
interest rate used to determine the present value. For example, $100
invested today in a savings scheme that offers a 10% interest rate
will grow to $110. In other words, $110 (future value) when
discounted by the rate of 10% is worth $100 (present value) as of
today. If one knows - or can reasonably predict - all such future cash
flows (like future value of $110), then, using a particular discount
rate, the present value of such an investment can be obtained.

2) Capital Asset Pricing Model?

CAPM evolved as a way to measure this systematic risk. Sharpe
found that the return on an individual stock, or a portfolio of stocks,
should equal its cost of capital. The standard formula remains the
CAPM, which describes the relationship between risk and expected
return.
The CAPM uses the principles of Modern Portfolio Theory to
determine if a security is fairly valued. It relies on assumptions about
investor behaviors, risk and return distributions, and market
fundamentals that don’t match reality. However, the underlying
concepts of CAPM and the associated efficient frontier can help
investors understand the relationship between expected risk and
reward as they make better decisions about adding securities to a
portfolio.
The Capital Asset Pricing Model (CAPM) describes the relationship
between systematic risk and expected return for assets, particularly
stocks. CAPM is widely used throughout finance for pricing
risky securities and generating expected returns for assets given the
risk of those assets and cost of capital.
The capital asset pricing model asserts that the investor should be
compensated in two ways: Time value of money and the Risk. The
time value of money means, the value of money today worth more
than the value of the same amount in the future. Thus, an investor is
compensated for employing a certain sum of money in a particular
investment over a period of time. The Time Value of money is
represented by “rf”i.e. A risk-free rate in the formula of CAPM.
The second part of the formula comprises of a risk; an investor
should be compensated for the additional risk that he bears by
placing his funds in a particular investment. The Risk is represented
by beta (β) that compares the returns on asset for a particular time
period against the market premium (Rm-Rf).
The Capital Asset Pricing is given by the following equation:
ra = rf +β (rm-rf)
Where,
ra = return on asset
rf = risk-free rate
β = risk premium
rm = market rate of return
The linear relationship between the return required on an
investment (whether in stock market securities or in business
operations) and its systematic risk is represented by the CAPM
formula, which is given in the Formulae Sheet:
The CAPM is an important area of financial management. In fact, it
has even been suggested that financial management only became an
academic discipline when William Sharpe published his derivation of
the CAPM in 1964.
CAPM assumptions
The CAPM is often criticised as unrealistic because of the
assumptions on which the model is based, so it is important to be
aware of these assumptions and the reasons why they are criticised.
The assumptions are as follows (Watson, D. and Head, A. (2016)
Corporate Finance: Principles and Practice, 7th edition, Pearson
Education Limited, Harlow pp.258-9).
Investors hold diversified portfolios
This assumption means that investors will only require a return for
the systematic risk of their portfolios, since unsystematic risk has
been diversified and can be ignored.
Single-period transaction horizon
A standardised holding period is assumed by the CAPM to make the
returns on different securities comparable. A return over six months,
for example, cannot be compared to a return over 12 months. A
holding period of one year is usually used.
Investors can borrow and lend at the risk-free rate of return
This is an assumption made by portfolio theory, from which the
CAPM was developed, and provides a minimum level of return
required by investors. The risk-free rate of return corresponds to the
intersection of the security market line (SML) and the y-axis (see
Figure 1). The SML is a graphical representation of the CAPM
formula.
Perfect capital market
This assumption means that all securities are valued correctly and
that their returns will plot on to the SML. A perfect capital market
requires the following: that there are no taxes or transaction costs;
that perfect information is freely available to all investors who, as a
result, have the same expectations; that all investors are risk averse,
rational and desire to maximise their own utility; and that there are a
large number of buyers and sellers in the market.
While the assumptions made by the CAPM allow it to focus on the
relationship between return and systematic risk, the idealised world
created by the assumptions is not the same as the real world in
which investment decisions are made by companies and individuals.
Real-world capital markets are clearly not perfect, for example. Even
though it can be argued that well-developed stock markets do, in
practice, exhibit a high degree of efficiency, there is scope for stock
market securities to be priced incorrectly and so for their returns not
to plot onto the SML.
The assumption of a single-period transaction horizon appears
reasonable from a real-world perspective, because even though
many investors hold securities for much longer than one year,
returns on securities are usually quoted on an annual basis.
The assumption that investors hold diversified portfolios means that
all investors want to hold a portfolio that reflects the stock market as
a whole. Although it is not possible to own the market portfolio
itself, it is quite easy and inexpensive for investors to diversify away
specific or unsystematic risk and to construct portfolios that ‘track’
the stock market. Assuming that investors are concerned only with
receiving financial compensation for systematic risk seems therefore
to be quite reasonable.
A more serious problem is that investors cannot in the real world
borrow at the risk-free rate (for which the yield on short-dated
government debt is taken as a proxy). The reason for this is that the
risk associated with individual investors is much higher than that
associated with the government. This inability to borrow at the risk-
free rate means that in practice the slope of the SML is shallower
than in theory.
Overall, it seems reasonable to conclude that while the assumptions
of the CAPM represent an idealised world rather than the real-world,
there is a strong possibility, in the real world, of a linear relationship
between required return and systematic risk.
Assumptions of Capital Asset Pricing Model
Investors are risk averse, i.e. they place funds in the less risky
investments.
All investors have the same expectations from the market and are
well informed.
No investor is big enough to influence the price of the securities.
The market is perfect: There are no taxes, no transaction costs,
securities are completely divisible, and the market is competitive.
Investors can borrow and lend unlimited amounts at a risk-free rate
(zero bonds).
Generally, the capital asset pricing model helps in the pricing of risky
securities, such that the implications of risk and the amount of risk
premium necessary for the compensation can be ascertained.

3) Efficient Market Hypothesis

The Efficient Market Hypothesis (EMH) essentially says that all
known information about investment securities, such as stocks, is
already factored into the prices of those securities. Therefore,
assuming this is true, no amount of analysis can give an investor an
edge over other investors, collectively known as "the market."
The efficient market hypothesis states that share prices reflect
all relevant information, and that it is impossible to beat the
market or achieve above-average returns on a sustainable basis.
There are many critics of this theory, such as behavioral
economists, who believe in inherent market inefficiencies.
EMH does not require that investors be rational; it says that
individual investors will act randomly, but as a whole, the market is
always "right." In simple terms, "efficient" implies "normal." For
example, an unusual reaction to unusual information is normal. If a
crowd suddenly starts running in one direction, it's normal for you to
run in that direction as well, even if there isn't a rational reason for
doing so.
There are three forms of EMH: weak, semi-strong, and strong. Here's
what each says about the market.
Weak Form EMH: Suggests that all past information is priced into
securities. Fundamental analysis of securities can provide an investor
with information to produce returns above market averages in the
short term, but there are no "patterns" that exist. Therefore,
fundamental analysis does not provide long-term advantage and
technical analysis will not work.
Semi-Strong Form EMH: Implies that neither fundamental analysis
nor technical analysis can provide an advantage for an investor and
that new information is instantly priced in to securities.
Strong Form EMH. Says that all information, both public and private,
is priced into stocks and that no investor can gain advantage over the
market as a whole. Strong Form EMH does not say some investors or
money managers are incapable of capturing abnormally high returns
because that there are always outliers included in the averages.
EMH does not say that no investors can outperform the market; it
says that there are outliers that can beat the market averages;
however, there are also outliers that dramatically lose to the market.
The majority is closer to the median. Those who "win" are lucky and
those who "lose" are unlucky.
Basically, the hypothesis implies that the pursuit of market-
beating performance is more about chance than it is about
researching and selecting the right stocks

4)Sharpe Index Ratio?

The Sharpe ratio was developed by Nobel laureate William
F.Sharpe and is used to help investors understand the return of
an investment compared to its risk. The ratio is the average return
earned in excess of the risk-free rate per unit of volatility or total risk.
Subtracting the risk-free rate from the mean return allows an
investor to better isolate the profits associated with risk-taking
activities. Generally, the greater the value of the Sharpe ratio, the
more attractive the risk-adjusted return
The Sharpe ratio is calculated by subtracting the risk-free rate from
the return of the portfolio and dividing that result by the standard
deviation of the portfolio’s excess return.
The Sharpe Index allows us to calculate the risk premium of an
investment fund for each unit of risk. Therefore, in theory, at any
time, the investor can choose to allocate his/her money to a "risk-
free" asset, or opt for an alternative investment as long as the
increase in risk is well-compensated for by the extra return to get.
Even if the concept of an appropriate remuneration of an investment
belongs to the bigger and better explained notion of the risk/return
profile of the investor, what is important to know here is that for
similar products with the same level of risk, it is possible to work out
a ratio (Sharpe Index) from which we can gather information
regarding the capability of a fund to generate a return for each unit
of risk.
This ratio is expressed as:

Risk Premium ( ) equals the difference between the average return

of the fund ( ) and the return of an operation that is free of risk
( ), whereas the risk of the fund is equal to its volatility (
).
The Sharpe Index gives information on how much extra return (risk
premium) a fund is capable of giving for each unit of risk (volatility),
and thus making it possible to compare investment funds that
have the same benchmark. As a result, funds with higher Sharpe
ratios have a preference over others, as they are capable of
generating greater returns for each unit of risk.
The Sharpe ratio adjusts a portfolio’s past performance—or expected
future performance—for the excess risk that was taken by the
investor.
A high Sharpe ratio is good when compared to similar portfolios or
funds with lower returns.
The Sharpe ratio has several weaknesses including an assumption
that investment returns are normally distributed.
Objective of the Study
The main objectives of the study are:
To get an insight into the idea embedded in Sharpe’s Single Index
Model.
To construct an optimal portfolio empirically using the Sharpe’s
Single Index Model .
To determine return and risk of the optimal portfolio constructed by
using Sharpe’s Single Index Model .

The Sharpe ratio has become the most widely used method for calculating the
risk-adjusted return. Modern Portfolio Theory states that adding assets to a
diversified portfolio that have low correlations can decrease portfolio risk
without sacrificing return.

Adding diversification should increase the Sharpe ratio compared to similar

portfolios with a lower level of diversification. For this to be true, investors
must also accept the assumption that risk is equal to volatility which is not
unreasonable but may be too narrow to be applied to all investments.

The Sharpe ratio can be used to evaluate a portfolio’s past performance (ex-
post) where actual returns are used in the formula. Alternatively, an investor
could use expected portfolio performance and the expected risk-free rate to
calculate an estimated Sharpe ratio (ex-ante).

The Sharpe ratio can also help explain whether a portfolio's excess returns are
due to smart investment decisions or a result of too much risk. Although one
portfolio or fund can enjoy higher returns than its peers, it is only a good
investment if those higher returns do not come with an excess of additional
risk.
The greater a portfolio's Sharpe ratio, the better its risk-adjusted performance.
If the analysis results in a negative Sharpe ratio, it either means the risk-free
rate is greater than the portfolio’s return, or the portfolio's return is expected
to be negative. In either case, a negative Sharpe ratio does not convey any
useful meaning.