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1.4 RISK AND RETURN ANALYSIS

(INCLUDING PORTFOLIO AND ASSETS PRICING MODELS)

Important Theories

Concept

Return includes regular income in the form of interest and dividend, and capital appreciation in the long run
as capital gain. Every investor wants to optimize return on his investment.

Risk is the probability that the expected return may not be realized. The basic relation between risk and
return is positive. That is higher the risk higher the return, lower the risk lower the return. Investors dislike
risk but want more return. Therefore, in a given situation if risks are equal he shall select investment with
higher return, and if returns are equal he shall select investment with lower risk. To optimize return and
minimize risk, investors diversify his investment and try to make efficient portfolio.

The value of investment is determined by risk and return, i.e., value of an investment is a function of the
expected size and riskiness of return from it. Investors prefer larger returns to small returns, hence risk
remaining the same, larger the expected return higher the investment value and vice versa. They dislike
risk. The dislike for risk is termed as risk-aversion. The degree of risk-aversion differs among investors and
over time. The relation between degree of risk-aversion and investment value is negative. i.e., as the
degree of risk-aversion increases, the value of investment decreases and vice-versa.

Return comprises the income, which is in the form of dividends or interest, and the capital gain (loss).
Return is calculated with the help of wealth ratio (refer to realized yield approach under cost of capital).

Risk refers to the possibility that the expected return may not materialize. There may be loss of capital, i.e.,
investment has to be sold for an amount less than paid for it. There may be no income from investment or
the income may be less than the expected. The natural query is "Why the investors go for risky
investments"? The answer is that that the desire for higher return entices them to go for risky investments.

Investments decision should be taken after consideration of both returns and risk. How to measure the
risk? Standard deviation of various possible rates of return is used to measure the risk, larger the standard
deviation, greater the risk and vice versa. If the expected returns from various investment proposals are
the same, decision may be taken on the basis of standard deviations, i.e., in this case we may go for
investment opportunity with lower standard deviation. If the expected returns from various proposals are
different, the choice out of various investment opportunities may be made on the basis of coefficient of
variation. i.e., standard deviation divided by expected return. Coefficient of variation defines risk as
standard deviation per rupee of expected return.

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Systematic and Unsystematic Risk

Systematic risk refers to variability in return on investment due to market factors that affect all investments
in a similar fashion. Examples of such factors are: Level of economic activities (recession or boom),
inflation, political developments, etc. unsystematic risk arises from such factors which are concerned with
the firm. Examples are: strike, change in management, special export order, etc. Unsystematic risk is also
called as diversifiable risk as it can be reduced with the help of diversification, i.e., instead of investing in
the shares of one company, one may invest in the shares of various companies, systematic risk is non-
diversifiable, it cannot be reduced through diversification. All equity investors have to bear this risk.

Beta

Beta is an indicator of an investment's systematic risk. It measures systematic risk associated with an
investment in relation to total risk associated with market portfolio. Suppose the beta value of a particular
security is 1.20, it means that if return of market folio varies by one per cent, the return from the security is
likely to vary by 1.20 per cent. Therefore, this security is riskier than the market because we expect its
return to fluctuate more than the market on a percentage basis. Thus beta measures the riskiness of an
individual security relative to market portfolio. It is a ratio of "its covariance with the market" to "the
variance of market as a whole". A security with beta greater than one is called aggressive security; with
beta less than one is called as defensive security and with beta equal to one is called as neutral security.

Covariance between returns from market

Beta = portfolio and those from particular security
Variance of market portfolio

Diversification

In layman terms, we call this concept as "Don't put all your eggs in one basket." The objective of
diversification is the risk reduction. The benefits of diversification, in the form of risk reduction, occur as
long as the securities are not perfectly, positively correlated. As the number securities selected for the
portfolio is increased, the total risk of the portfolio is reduced. Such a reduction can be achieved by making
combinations of securities with negative or lower positive correlation. If a portfolio is efficiently diversified,
unsystematic risk can be reduced to zero. Therefore, the important risk of a stock is its unavoidable or
systematic risk. Investors can expect to be compensated for bearing this systematic risk. They should not,
however, expect the market to provide any extra compensation for bearing avoidable risk. It is this logic
that lies behind the capital-asset pricing model. The CAPM rests on eight assumptions.
1. The investor's objective is to maximize the utility of terminal wealth
2. Investors make choices on the basis of risk and return
3. Investors have homogenous expectations of risk and return
4. Investors have identical time horizon
5. Information is freely and simultaneously available to investors
6. There is a risk-free asset and investors can borrow and lend unlimited amounts at the risk-free rate

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7. There are no taxes, transaction costs, restrictions on short rates, or other market imperfections
8. Total asset quantity is fixed and all assets are marketable and divisible

The Capital Market line

(It is linear efficient frontier or equilibrium pricing relationship)

It is an alternative combination of risk and return obtainable by combining the efficient market portfolio with
borrowing or lending. All investment strategies other than those employing the market portfolio and
borrowing or lending below the capital market line are an efficient market, although some may plot very
close to it.

The slop of the capital market line can be regarded as the reward per unit of risk borne. This slop is in the
proportion of risk except for risk free rate. The reward for waiting (delay consumption) or risk less interest
rate is the starting point of the CML and it increases with the proportion of risk. In essence the capital
market line provides a place where time and risk can be traded (i.e. for time risk free and for risk, risk
premium) and their prices determined by the forces of demand and supply.

The Security Market Line

(Do not consider total risk, only systematic risk)

The CML defines the relationship between total risk and expected return for portfolios consisting of the
risk-free asset and the market portfolio. The capital asset pricing model identifies security return net of the
risk-free rate as proportional to the expected net market return. As a consequence of this relationship, all
securities in equilibrium plot along a straight line called the security market line (SML). Since the
unsystematic risk tends to be diversified away by the construction of efficient portfolio, it is desirable to
develop an alternative to CML which will use beta as the independent variable. SML is a linear relationship
between the expected return and beta or systematic risk on which both portfolios and individual securities
can lie whereas CML is a linear relationship between the expected return of a portfolio and the total risk
associated with it; it generates a line on which efficient portfolio can lie.

Portfolio Management

In general terms, portfolio means combination of anything. In the context of finance it is a combination of
securities. In other words, portfolio means the total holdings of securities belonging to any person.
Portfolio management in common parlance refers to the selection of securities and their continuous shifting
in the portfolio to optimize returns to suit the objectives of an investor. This, however, requires financial
expertise in selecting the right mix of securities in the changing market conditions.

Portfolio manager means any person who enters into a contract or arrangement with a client and pursuant
to such agreement he advises the client or undertakes on behalf of such client management or
administration of a portfolio of securities or investment and manages the client's funds.
A discretionary portfolio manager means a portfolio manager who exercises or may, under a contract
relating to portfolio management, exercise any degree of discretion in respect of the investments or
management of the portfolio.

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A non-discretionary, portfolio manager shall manage the funds in accordance with the directions of the
client.
The main objectives of portfolio management are:
1. Security/safety of Principal
2. Stability of income
3. Capital growth
4. Marketability i.e. the case with which a security can be bought or sold.
5. Liquidity i.e. nearness to money.
6. Diversification
7. Favourable tax status.

Functions of Portfolio Managers

Merchant banks and portfolio managers rendering the services of portfolio management to their clients in
different categories, have to enquire of their respective individual objectives, need pattern for funds,
perspective towards growth and attitude towards risk before counseling them on the subject and
acceptance of the assignment. Nevertheless, portfolio managers in the wake of rendering their services
perform following set of functions:

1. They study economic environment affecting the capital market and clients investment.
2. They study securities market and evaluate price trend of share and securities in which investment is
to be made.
3. They maintain complete and updated financial performance date of blue-chip and other companies.
4. They keep a track on the latest policies and guidelines of Government, central bank and stock
exchanges.
5. They study problems of industry affecting securities market and the attitude of investors.
6. They study the financial behaviour of other players in the capital market to find out sentiments in the
capital market.
7. They counsel the prospective investor's on share market and suggest investments in certain assured
securities.
8. They carry out investment in securities or sale or purchase of securities on behalf of the clients to
attain maximum return at lesser risk.

The services of portfolio managers may be discretionary or non-discretionary. The advantage offered by
discretionary service is that the manager can react quickly to market changes without consulting the
investor. A portfolio manager acts as a personal financial consultant on investment decisions. He also
offers other value added services such as tax planning, benefit collection, safe custody of securities,
registration and transfers, etc.

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Activities in Portfolio Management

The following three major activities are involved in an efficient portfolio management:
a) Identification of assets or securities classes.
b) Deciding about major weights proportion of different assets /securities in the portfolio.
c) Security selection within the asset classes as identified earlier.
The above activities are directed to achieve the sole purpose to maximize return and minimize risk in the
investments.
The portfolio manager envisages balancing the risk and return in a portfolio investment. With higher risk,
higher returns may be expected and vice-versa.

Types of Risk in the Context of Portfolio Management

The composite risk includes different risk indicated below:

1. Interest rate risk: This arises due to variability in the interest rates from time to time. A change in the
interest rates establishes an inverse relationship in the price of security i.e. price of securities tends to
move inversely with change in rate of interest.

2. Purchasing power risk: It is also known as inflation risk also emanates from the fact that inflation
affects the purchasing power adversely. Purchasing power risk is more in inflationary conditions
especially in respect of bonds and fixed income securities. It is not desirable to invest in such
securities during inflationary periods.
3. Business risk: Business risk emanates from sale and purchase of securities affected by business
cycles, technological changes, etc. Variable income securities are more affected than fixed rate
securities during depression due to decline in their market price.

4. Financial risk: It arises due to changes in the capital structure of the company. It is also known as
leveraged risk and expressed in terms of debt-equity ratio. Although levered companies earning per
share are more such company exposes the risk of winding-up for its inability to honour its
commitments towards lenders/creditors.

Basic Principles of Portfolio Management

There are two basic principles for effective portfolio management.

1. Effective investment planning by considering:

a) Fiscal, financial and monetary policies of the Government and the Central Bank.
b) Industrial and economic environment and its impact on industry prospects.

2. Constant review of investment: Portfolio managers are required to review their investment in
securities and continue shifting their investment in more profitable avenues. For this purpose they will
have to carry the following analysis:

a) Assessment of quality of management.

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b) Financial and trend analysis of companies balance sheet/profit and loss account to identify
sound companies with optimum capital structure and better performance.
c) The analysis of securities market and its trend is to be done on a continuous basis.
This will help to arrive at a conclusion as to whether the securities already in possession should be
disinvested and new securities be purchased. If so, the timing for investment or dis-investment is also
revealed.
The timing of buying and selling the securities, especially shares, is of crucial importance. Even if one can
identify correctly the companies in whose shares the investments are to be made. One may lose money if
the timing is bad due to wide fluctuation in the price of shares. It is obvious that if a person wishes to make
any gains, he should "by cheap and sale dear" i.e. by when the shares are selling at a low price and sell
when they are at a high price. This requires identification of bullish and bearish trends in the prices of
stocks in the share market.

Identifying Industries or Securities with Growth Potential

We have already seen that after the objects of investment portfolio in terms of risk and return have been
specified, one of the first decisions that an investment manager faces is to identify the industries which
have a high growth potential. Two approaches are suggested as fundamental in this regards:

a) Statistical analysis of past performance: A statistical analysis of the immediate past performance
of the various industries and changes therein related to the general price index of shares of all
industries should be made. The analysis of share price indices over a number of years will enable the
investment manager to identify the industries which are rated high by the investors at the time of
analysis.
b) Assessing the intrinsic value: After an investment manager has identified statistically the industries
in the share of which the investors show interest, he would assess the various factors which influence
the value of a particular share. The strengths and weakness of the company, characteristics of the
industry within which the company falls and economic scene. It is the job of the investment manager
to examine and weight the various factors and judge the quality of the share or the security under
consideration. This approach is known as the intrinsic value approach.

In identifying industries and companies, both qualitative and quantitative factors are to be considered.
The following factors may particularly be kept in mind while assessing the industry:

a) Demand/supply pattern for the industry's products and its growth potential
b) Profitability: The cost structure of the industry as related to its sale price is an important
consideration. The investment manager, therefore, may analyze the profitability ratios; especially
return on investment, gross profit ratio and net profit ratio.
c) Particular characteristics of the industry: For example, certain industries have a fast changing
technology. Cycles or fluctuations in earnings must be carefully studied. E.g. seasonal industry.

d) Labour management relations in the industry: Once the industry's characteristics have been analyzed
and certain industries with growth potential identified, the next stage would be to undertake and
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analyze all the factors which show the desirability of the various companies within an industry group
from investment point of view.

After the selection of industry, the next step is the selection of company within the industry. Before
purchasing the shares of a company, relevant information must be collected and properly analyzed. An
illustrative list of the factors which help the analyst in taking the investment decision is given below.
However, it must be emphasized that past performance and information is relevant only to the extent it
indicates the further trends. Hence, the investment manager has to visualize the performance of the
company in further by analyzing its past performance.
1. Size and ranking: In this regard the net capital employed, the net profits, the return on investment and
the sales figures of the company under consideration may be compared with similar data of other
companies in the same industry group.
2. Growth record: The following three growth indicators may be particularly looked into: (i) Price
earnings ratio, (ii) Percentage growth rate of earning per annum, and (iii) Percentage growth rate of
net block. The price earnings ratio is an important indicator to determine whether the share is under-
priced or over-priced. If other factors like intrinsic value of share, growth potential, etc are quite
similar, it is obvious that the shares of company with lower price earnings ratio are preferable. The
percentage growth rate of net blocks shows how the company has been developing its capacity
levels. The plans of the company, in terms of expansion or diversification, can be known from the
Director's Reports, the Chairman's statements and from the further capital commitments as shown by
way of notes in the balance sheets. A company may have a good record of profits and performance
in the past; but if it does not have growth potential, its shares cannot be rated high from the
investment point of view.

3. Financial Analysis: An analysis of its financial statements for the past few years would help the
investment manager in understanding the financial solvency and liquidity, the efficiency with which
the funds are used, the profitability, the operating efficiency and the financial and operating leverages
of the company. From the investment point of view, the most important figures are earnings per
share, price earning ratios, yield, book value and the intrinsic value of the share.
4. Quality of management: Quality of management has to be seen with reference to the experience,
skills and integrity of the persons. The policy of the management regarding relationship with other
stake holders, dividend and bonus distributions, etc.
5. Location and labour-management relations: Availability of crucial inputs like power, skilled labour and
raw-materials, etc. Nearness to markets is also a factor to be considered.
6. Pattern of existing stock holding: whether shares are closely held or widely held by the public.
Companies whose shares are widely distributed to the public are considered safe and less risky.
7. Marketability of the shares: Mere listing of a share on the stock exchange does not automatically
mean that the share can be sold or purchased at will. In this regard, dispersal of shareholding with
special reference to the extent of public holding should be seen. The other relevant factors are the
speculative interest in the particular scrip, and the volume of trading.

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Fundamental analysis thus is basically an examination of the economic and financial aspects of a
company with the aim of estimating future earnings and dividend prospects.

Investment Strategy

Portfolio manager can follow either active or passive strategy. Active strategy is based on the assumption
that it is possible to beat the market. This is done by selecting assets that are viewed as underpriced or by
changing the asset mix or proportion of fixed income securities and shares. Active strategy is carried out
as follows:
1. Aggressive security management: Aggressive purchasing and selling of securities to achieve high
yields from dividend, interest and capital gains.
2. Speculation and short term trading: The objective is to gain capital profits. The risk is high and the
composition of portfolio is flexible.
Success of active strategy depends on correct decisions as regards the timing of investment and selection
and mix of securities.

The passive strategy does not aim at outperforming the market. Unlike in the active strategy, the stocks
could be randomly selected on the assumption of a perfectly efficient market. The objective is to include in
the portfolio a large number of securities so as to reduce risks specific to individual security. The
characteristics of passive strategy are:

1. Long term investment horizon.

2. Little portfolio revisions.

Thus it is basically a buy and hold strategy.

Portfolio Theories
Portfolio theory can be discussed under two heads:
1. Traditional Approach
2. Modern Approach

Traditional approach

The traditional approach to portfolio management concerns itself with the investor, definition of portfolio
objectives, investment strategy, diversification and selection of individual investment as detailed below:
1. Investor's study includes an insight into his (a) age, health, responsibilities, other assets, portfolio
needs; (b) need for income, capital maintenance, liquidity; (c) attitude towards risk; and (d) Taxation
status;
2. Portfolio objectives are defined with reference to maximizing the investor's wealth which is subject to
risk.
3. Investment strategy covers examining a number of aspects including:
a) Balancing fixed interest securities against equities;
b) Finding growth portfolio;

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c) Balancing income tax payable against cost of transaction and capital gain tax if tax rate is
different;
d) Retaining some liquidity to seized upon bargains.
4. Adequate equity diversification so as to reduce risk and optimize return.
5. Selection of individual investments is made on the basis of the following principles:
i) By calculating the true or intrinsic value of securities.
ii) Expert advice is sought.
iii) Inside information is sought.
iv) Newspaper tipsters about good track record of companies.
iv) Companies with good asset backing, dividend growth, good earning record and high quality
management.

Dow Jones Theory

It is probably the most popular theory regarding the behaviour of stock market prices. The theory derives
its name from Charles H. Dow, who established the Dow Jones & Co., and was the first editor of the wall
street Journal in the USA.
The Dow Jones theory classifies the movements of the prices on the share market into three major
categories:
1. Primary movements,
2. Secondary movements and
3. Daily fluctuations.

1. Primary movements: If the long range behaviour of market prices is seen, it will be observed that the
share markets go through definite phases, where the prices are consistently rising or falling. These
phases are known as bull and bear phases. During a bull phases, the basic trend is that of rise in
prices. P3

T3

P2

P1
T2

T1

Bull Phase Graph

P3>P2>P1 & T3>T2>T1

Students would notice from the graph that although the prices fall after each rise, the basic trend is
that of rising prices. This means that prices do not rise consistently even in a bull phase. They rise for
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some time and after each rise, they fall. However, the falls are of a lower magnitude than earlier. As a
result, prices reach higher levels with each rise.
Once the prices have risen very high the bear phase is bound to start i.e. price will start falling. It
would be seen that prices are not falling consistently and, after each fall, there is a rise in prices.
However, the rise is not much as to take the prices higher than the previous peak. It means that each
peak and trough is now lower than the previous peak and trough. The theory argues that primary
movements indicate basic trends in the market.

P1

P2

T1 P3

T2

Bear Phase T3
GraphP1>P2>P3 & T1>T2>T3
It states that if cyclical swings of stock market price indices are successively higher, the market trend
is up and there is a bull market. On the contrary, if successive highs and lows are successively lower,
the market is on a downward trend and we are in a bear market.
2. Secondary movements: When the primary trend is upward, there are also downward movements of
prices. Similarly, even where the primary trend is downward, there are upward movements of prices
also. These movements are known as secondary movements and are shorter in duration and are
opposite in direction to the primary movements.

3. Daily movements: There are irregular fluctuations which occur every day in the market. These
fluctuations are without any definite trend. These fluctuations are the result of speculative factors. An
investment manager really is not interested in the short run fluctuations in share prices since he is not
a speculator.

Ideally speaking the investment manager would like to purchase shares at a time when they have reached
the lowest trough and sell them at a time when they reach the highest peak. However, in practice he buys
the shares when they are on the rise and sells them when they are on the fall.

Random Walk Theory

Many investment managers and stock market analysts believe that stock market prices can never be
predicted because they are not a result of any underlying factors but are mere statistical ups and downs.

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This hypothesis is known as Random Walk hypothesis which states that the behaviour of stock market
prices is unpredictable and that there is no relationship between the present prices of the shares and their
future prices. Proponents of this hypothesis argue that stock market prices are independent. In other
words, the fact that there are peaks and troughs in stock exchange prices is a mere statistical happening
successive peak and troughs are unconnected. In the layman's language it may be said that prices on the
stock exchange behave exactly the way a drunk would behave while walking in a blind lane, i.e. up and
down, with an unsteady way going in any direction he likes, bending on the side once and on the other
side the second time.

Formula Plans

Under the formula plans, the total investible funds are divided into two major categories.
1. A specified percentage say 50% is to be invested in fixed income securities.
2. The second part is invested in securities yielding variable dividends like ordinary shares.
The second main feature of formula plan is that at predetermined interval say, three months or six months
or so, the market value of the total investment portfolio is worked out. Now, according to our predetermined
percentage, only 50% of this should be in variable dividend shares. Hence, we will have to shift as per the
need. For this we may sell shares immediately and invest the proceeds in fixed deposit or vice versa.
Thus, we are forced to sell shares and variable dividend securities, in case the price of such securities has
gone up or buy out of deposit when the price falls.

Basic Questions
Question 1

Mr. Kalu has analyzed a stock for one-year holding period. The stock is currently selling for Rs. 10 but
pays no dividends, and there is fifty-fifty chance that the stock will sell for either Rs. 10 or Rs. 12 by year
end. What is the expected return and risk if 500 shares are acquired? [Ans. 10%, 10%]

Question 2

Stock Q and R do not pay dividends. Stock Q currently sells for Rs. 50 and R for Rs. 100. At the end of the
year ahead there is a fifty-fifty chance that Q will sell for either Rs. 61 or Rs. 57 and R for either Rs. 117 or
Rs. 113. Which stock, Q or R would you prefer to purchase now?

Question 3

Calculate the expected return and the standard deviation of return for a stock having the following
probability distribution.

Return (%) Probability of occurrence

-24 0.05
-10 0.15
0 0.15

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12 0.20
18 0.20
22 0.15
30 0.10

Question 4

Jenson & Nicholson, a paint company has the following dividend per share and the market price per share
for the period 1987-92:

Year Dividend per share Market price

1987 1.53 31.25
1988 1.53 20.75
1989 1.53 30.88
1990 2.00 67.00
1991 2.00 100.00
1992 3.00 154.00

Calculate the annual rates of return of Jenson’s shares for last 5 years. Also calculate the risk of the share.

Question 5

Following is the data relating to six securities:

A B C D E F
Return 8 8 12 6 9 8
Risk 4 6 12 4 5 7

Which are the securities to be selected? Plot it in graph.

Question 6

A stock's return has the following distribution:

Demand of the Probability of This Rate of Return

Company's Products Demand Occurring If This Demand Occurs
Weak 0.1 (50%)
Below average 0.2 (5)
Average 0.4 16
Above average 0.2 25
Strong 0.1 60
1. 0

Calculate the stock's expected return, standard deviation, and coefficient of variation.

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Question 7

An individual has Rs.35,000 invested in a stock which has a beta of 0.8 and Rs.40,000 invested in a stock
with a beta of 1.4. If these are the only two investments in her portfolio, what is her portfolio's beta?

Question 8

Assume that the risk-free rate is 5 percent and the market risk premium is 6 percent. What is the expected
return for the overall stock market? What is the required rate of return on a stock that has a beta of 1.2?

Question 9

Assume that the risk-free rate is 6 percent and the expected return on the market is 13 percent. What is
the required rate of return on a stock that has a beta of 0.7?

Question 10

The market and Stock J have the following probability distributions:

Probability rm rj
0.3 15% 20%
0.4 9 5
0.3 18 12

a) Calculate the expected rates of return for the market and Stock J.

b) Calculate the standard deviations for the market and Stock J.

c) Calculate the coefficients of variation for the market and Stock J.

Question 11

Suppose rRF =5%, rM =10%, and rA = 12%.

a) Calculate Stock A's beta.
b) If Stock A's beta were 2.0, what would be A's new required rate of returns?

Question 12

Suppose rRF =9%, rM =14%, and bi = 1.3.

a) What is r i, the required rate of return on Stock i?
b) Now suppose rRF (1) were increases to 10 percent of (2) decreases to 8 percent. The slope of the
SML remains constant. How would this affect rM and ri ?
c) Now assume rRF remains at 9 percent but rM (1) increases to 16 percent or (2) falls to 13 percent. The
slope of the SML does not remain constant. How would these changes affect ri?

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Question 13

Suppose you hold a diversified portfolio consisting of a Rs.7,500 investment in each of 20 different
common stocks. The portfolio beta is equal to 1.12. Now, suppose you have decided to sell one of the
stocks in your portfolio with a beta equal to 1.0 for Rs.7,500 and to use these proceeds to buy another
stock for your portfolio. Assume the new stock's beta is equal to 1.75. Calculate your portfolio's new beta.

Question 14

Suppose you are the money manager of a Rs.4 million investment fund. The fund consists of 4 stocks with
the following investments and betas:

Stock Investment Beta

A Rs. 400,000 1.50
B 600,000 (0.50)
C 1,000,000 1.25
D 2,000,000 0.75

If the market required rate of return is 14 percent and the risk-free rate is 6 percent, what is the fund's
required rate of return?

Question 15

You have a Rs.2 million portfolio consisting of a Rs.100,000 investment in each of 20 different stocks. The
portfolio has a beta equal to 1.1. You are considering selling Rs.100,000 worth of one stock which has a
beta equal to 0.9 and using the proceeds to purchase another stock which has a beta equal to 1.4. What
will be the new beta of your portfolio following this transaction?

Question 16

Stock R has a beta of 1.5, Stock S has a beta of 0.75, the expected rate of return on an average stock is
13 percent, and the risk-free rate of return is 7 percent. By how much does the required return on the
riskier stock exceed the required return on the less risky stock?

Question 17

Stock A and B have the following historical returns:

Year Stock A's Returns, rA Stock B's Returns, rB

2000 (18.00%) (14.50%)
2001 33.00 21.80
2002 15.00 30.50
2003 (0.50) (7.60)
2004 27.00 26.30

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a) Calculate the average rate of return for each stock during the 5-year period.
b) Assume that someone held a portfolio consisting of 50 percent of Stock A and 50 percent of Stock B.
What would have been the realized rate of return on the portfolio in each year? What would have
been the average return on the portfolio during this period?
c) Calculate the standard deviation of returns for each stock and for the portfolio.
d) Calculate the coefficient of variation for each stock and for the portfolio.
e) If you are risk-averse investor, would you prefer to hold Stock A and Stock B, or the portfolio? Why?

Question 18

You have observed the following returns over time:

Year Stock X Stock Y Market

2000 14% 13% 12%
2001 19 7 10
2002 -16 -5 -12
2003 3 1 1
2004 20 11 15

Assume that the risk-free rate is 6 percent and the market risk premium is 5 percent.
a) What are the betas of Stocks X and Y?
b) What are the required rates of return for Stocks X and Y?

c) What is the required rate of return for a portfolio consisting of 80 percent of Stock X and 20 percent of
Stock Y?

d) If Stock X's expected return is 22 percent, is Stock X under or overvalued?

Question 19

ECRI Corporation is a holding company with four main subsidiaries. The percentage of its business
coming from each of the subsidiaries, and their respective betas, are as follows:

Subsidiary Percentage of Business Beta

Electric utility 60% 0.70
Cable company 25 0.90
Real estate 10 1.30
International / special projects 5 1.50

a) What is the holding company's beta?

b) Assume that the risk-free rate is 6 percent and the market risk premium is 5 percent. What is the
holding company's required rate of return?

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c) ECRI is considering a change in its strategic focus: it will reduce its reliance on the electric utility
subsidiary, so the percentage of its business from this subsidiary will be 50 percent. At the same
time, ECRI will increase its reliance on the international / special projects division, so the percentage
of its business from that subsidiary will rise to 15 percent. What will be the shareholders required rate
of return if they adopt these changes?

Question 20

Stock A and B have the following historical returns:

Year Stock A's Returns, rA Stock B's Returns, rB

2000 (18%) (24%)
2001 44 24
2002 (22) (4)
2003 22 8
2004 34 56
a) Calculate the average rate of return for each stock during the 5-year period. Assume that someone
held a portfolio consisting of 50 percent of Stock A and 50 percent of Stock B. What would have been
the realized rate of return on the portfolio in each year? What would have been the average return on
the portfolio during this period?
b) Now calculate the standard deviation of returns for each stock and for the portfolio.
c) Looking at the annual returns data on the two stocks, would you guess that the correlation coefficient
between returns on the two stocks is closer to 0.8 or to -0.8?
d) If you added more stocks at random to the portfolio, which of the following is the most accurate
statement of what would happen to standard deviation ( σP )?

1) σP would remain constant.

2) σP would decline to somewhere in the vicinity of 20 percent.

3) σP would decline to zero if enough stocks were included.

Question 21

The stock of Box Limited performs well relative to other stocks during recession periods. The stock of Cox
Limited, on the other hand, does well during growth periods. Both the stocks are currently selling for Rs.
100 per share. You assess the rupee return (dividend plus price) of these stocks for the next year as
follows:

Economic Condition
High growth Low growth Stagnation Recession
Probability 0.3 0.4 0.2 0.1
Return on Box’s stock 100 110 120 140
Return on Cox’s stock 150 130 90 60

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Calculate the expected return and standard deviation of investing:

a) Rs. 1000 in the equity stock of Box Limited.
b) Rs. 1000 in the equity stock of Cox Limited.
c) Rs. 500 each in the equity stock of Box and Cox Limited.

Question 22

The returns on security and the market index for a 10 year period are given below. You are required to
calculate the Beta of the securiy.

Year Return on security Return on Market Index

(%) (%)
1 10 12
2 6 5
3 13 18
4 -4 -8
5 13 10 [Ans: Beta of the security =
6 14 16 0.76]
7 4 7
8 18 15
9 24 30
10 22 25

Question 23

The risk-free return is 9%. The required on a stock whose beta is 1.5 is 15 %. What is the expected return
on the market portfolio?

Question 24

The results of four portfolio managers are as follows:

Portfolio Manger Average return (%) Beta

A 13 0.80
B 14 1.05
C 17 1.25
D 13 0.90

Select the manger with best performance if risk free return is 8% & return on market portfolio is 14%.

Question 25

The equity shares of A company and B company have expected return of 15% and 20% respectively, while
the standard deviations are 0.25 and 0.40. What would be the expected return and risk of a portfolio

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consisting of A and B stocks in the ratio of 3:2 respectively, if coefficient of correlation between the two
stocks is (a) 0.45 (b) 1.0 and (c) Zero.

Question 26

Two shares, P and Q have the following expected returns, standard deviation and correlation:

Stocks
P Q
Expected Return 18% 15%
Standard Deviation 23% 19%
PPQ = 0

a) Determine the minimum risk combination for a portfolio of P and Q.

b) If the correlation of returns of P and Q is -1.0, then wh0at is the minimum risk portfolio of P and Q ?

Question 27

Returns on shares of P Ltd. and Q Ltd. for the past two years are as under:

2000 2001
P Ltd. 11% 17%
Q Ltd. 20% 8%
Calculate the following:
a) Expected return of portfolio made up 50 percent of P and 50 percent of Q.
b) Expected return of portfolio made up of 60 percent of P and 40 percent of Q.
c) Find out standard deviation of each stock.
d) What is the covariance and coefficient of correlation between P and Q.
e) If P & Q stock is invested in the ratio of 2/3:1/3 what is portfolio risk.
f) If the ratio of investment in P & Q is 1:1 then what is the overall portfolio risk and why it has gone up.

Question 28

L Ltd. and M Ltd. have the following risk and return estimates.
RL = 20%
RM = 22%
σM = 18%
σL = 15%
(Correlation Coefficient = rLM = -1)

Calculate the proportion of investment in Ltd and M Ltd. to minimize the risk of portfolio.

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Question 29

P Ltd. and Q Ltd. have low positive correlation coefficient of + 0.5. Their respective risk and return profile is
as under:
RP = 10%
RQ = 15%
σP = 20%
σQ = 25%

Compute the portfolio of P & Q to minimize risk.

Question 30

Novex owns a portfolio of two securities with the following expected returns, standard deviations and
weights.
Security Expected Return Standard Deviation Weight
X 12% 15% 0.40
Y 15% 20% 0.80
What are the maximum and minimum portfolio standard deviations for varying levels of correlation
between two securities?

Question 31

You are considering purchasing the equity stock of MVM Company. The current price per share is Rs. 10.
You expect the dividend a year hence to be Re. 1. You expect the price per share of MVM stock a year
hence to have the following probability distribution:
Price a year hence (Rs.) 10 11 12
Probability 0.4 0.4 0.2
a) What is the expected price per share a year hence?
b) What is the probability distribution of the rate of return on MVM’s equity stock and find out expected
return & risk of equity.

Question 32

The risk-free return is 8% and the expected return on market portfolio is 12%. If the required return on a
stock is 15%, what is its beta?

Question 33

The following are the returns of share S and the market (M) for the last 6 years:

Year Returns (%)

S M
1991 18 15
1992 9 7

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1993 20 16
1994 -10 -13
1995 5 4
1996 12 7

Calculate the beta of share S and systematic and unsystematic risk of share.

Question 34

A financial consultant of Exe Ltd. recommends that the firm should estimate its return on equity by applying
the capital assets pricing model (CAPM) from the following facts:
a) Systematic risk of the firm is 1.4
b) 182 days Govt. treasury bills currently yield 8%.
c) Expected yield on the market portfolio of assets is 13%.
Determine the return on equity based on the above data.

Question 35

The risk-free return is 10% and the return on market portfolio is 15%. Stock A’s beta is 1.5; its dividends
and earnings are expected to grow at the constant rate of 8%. If the previous dividend per share of stock A
was Rs. 2.00, what should be the intrinsic value per share of stock A?

Question 36

The required return on the market portfolio is 12%. The beta of stock X is 2.0. The required return on the
stock is 18%. The expected dividend growth on stock X is 5%. The price per share of stock X is Rs. 30.
What is the expected dividend per share of stock X next year? What will be the combined effect of the
following on the price per share of stock X?
a) The inflation premium increases by 2%.
b) The decrease in the degree of risk-aversion reduces the differential between the return on market
portfolio and the risk-free return by one-third.
c) The expected growth rate of dividend on stock X decreases to 4%.
d) The beta of stock X falls to 1.8.

Question 37

The risk-free rate of return Rf is 9%. The expected rate of return on the market index Rm is 13%. The
expected rate of growth for the dividend of firm A is 7%. The last dividend paid on the equity stock of firm A
was Rs. 2.00. The beta of firm A’s equity stock is 1.2.
a) What is equilibrium price of the equity stock of firm A?
b) How would the equilibrium price change in each case separately when- (1) the inflation premium
increases by 2%,
(2) The expected growth rate increases by 3% and (3) the beta of A’s security rises to 1.3?

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Question 38

a. Plot the following risky portfolios on a graph:

Portfolio A B C D E F G H
Expected return (r), % 10 12.5 15 16 17 18 14 20
Standard deviation (σ), % 23 21 25 29 29 32 35 45

b. Five of these portfolios are efficient, and there are not. Which are inefficient ones?
c. Suppose you can also borrow and lend at an interest rate of 12 percent. Which of the above portfolio
is best?
d. Suppose you are prepared to tolerate a standard deviation of 25%. What is the maximum expected
return that you can achieve if you cannot borrow or lend?
e. What is your optimal strategy if you can borrow or lend at 12 percent and are prepared to tolerate a
standard deviation of 25 percent? What is the maximum expected return that you can achieve?

Question 39

A portfolio consists of three securities A, B and C in the proportion of 3:2:5. The securities are having the
expected return of 15%, 10% and 20% with standard deviations of 0.4, 0.3 and 0.5 respectively. The
correlations between A & B, A & C, and B & C are 0.4, 0.5 and 0.6 respectively. Find out the Portfolio
Return and Portfolio Risk.

Question 40

The following data is available of XYZ investments Ltd. for investment in different securities:

Security X Y Z
Mean Return (Ri) (%) 20 30 40
Standard Deviation 4 5 3
Correlation (P) Pxy=0.4 Pyz=-0.6 Pxz=-1

You as a financial risk analyst are required to calculate expected Return and Risk of each of the following
portfolios:
a) The investor invests equally in each security.
b) The investor invests 40% in X, 40% in Y and 20% in Z.
c) The investor invests 30% in X, 30% in Y and 40% in Z.

Question 41

From the following data of Birla Growth Mutual Fund, calculate the Expected Return and Risk of the
Portfolio which includes the following securities:

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Event Probability Returns on Securities (%)

X Y
Boom 20 -10 -10
Recession 40 25 25
Stagnation 30 20 20
Depression 10 10 10

Calculate the expected Return and Risk [standard deviation] of the portfolio, if the fund has invested 60%
money is security X and 40% in security Y.

Question 42

You are given the two stocks of ABC and XYZ with a standard deviation 0.05 and 0.10 respectively. The
correlation coefficient for these two stocks is 0.8. What is the diversification gain from forming a portfolio
that has equal proportions of each stock?

Question 43

You are evaluating an investment in two companies whose past ten years of returns are shown below:

Companies Percent Return during the year

1 2 3 4 5 6 7 8 9 10
Fast 37 24 -7 6 18 32 -5 21 18 6
Slow 32 29 -12 1 15 30 0 18 27 10

a) Calculate the standard deviation of each company’s returns.

b) Calculate the correlation coefficient of the companies returns.
c) If you had placed 50% of your money in each, what would have been the standard deviation of your
portfolio and the average yearly return?
d) What percentage investment in each would have resulted in the lowest risk?
e) If yearly risk-free return of 8% was available and that you had held only one of the two companies.
Which would have been the better to own?
f) What is the single efficient portfolio of the two securities, and its Return and Risk.
g) If efficient portfolio is combined with Risk-Free security by lending or borrowing, how an average
return of 10.8% and 17.8% would have been obtained?
f) Return 15%, Standard deviation (minimum) 13.889 %
g) To earn 10.8% invest 60% risk-free and 40% in risky portfolio.
To earn 17.8%, borrow 40% risk-free and invest 140% in risky portfolio.]

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Question 44

An investor, Peter, holds a portfolio, which is expected to yield a rate of return of 18% with a standard
deviation of return of 25%. The investor is considering of buying a new share (investment being 5% of the
total investment in the new portfolio). The new share has the following distribution of return.

Return (%) 40 30 10
Probability 0.3 0.4 0.3 .
If the correlation coefficient is, between the return from old portfolio and the new security, +0.25, calculate
the portfolio return and the standard deviation of return of the new portfolio.

Question 45

Shyam owned five securities at the beginning of the year in the following amounts and with the following
current and expected end of year prices.

Security No. of shares Current Price Year end price of share

A 100 50 65
B 150 30 40
C 75 20 25
D 100 25 32
E 125 40 47

Determine the expected return on Shyam’s portfolio/Market Portfolio for the year.

Question 46

Mr. Strong has the following portfolio consisting of five securities. Calculate Strong’s Portfolio’s expected
return / Return on Market portfolio:
Stock Initial Investment End-of-period % of stock in
Value (Rs.) invest. Value portfolio
A 5000 7000 20
B 2500 4000 10
C 4000 5000 16
D 10000 12000 40
E 3500 5000 14

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Question 47

As an investment manager you are given the following information:

Investment in equity share Initial Price Dividends Market price at Beta Risk
of Co. Rs. Rs. end of the year Factor
Rs.
Cement Ltd. -25 2 50 0.8
Steel Ltd. 35 2 60 0.7
Liquor Ltd. 45 2 135 0.5
Govt. of India Bonds 1000 140 1005 0.99

You are required to calculate:

a) Expected rate of return of Market Portfolio in each using CAPM, if risk free return is 14%.
b) Average return of portfolio, if equal investment is made in each security.

Question 48

An investor is seeking the price to pay for a security, whose standard deviation is 3%. The correlation
coefficient for the security with the market is 0.8 and the market standard deviation is 2.2%. The return
from Government securities is 5.2% and from the market portfolio is 9.8%. The investor knows that, by
calculating the required rate of return, he can then determine the price to pay for the security. What is the
required return on the security?

Question 49

Calculate the market sensitivity index and the expected return on the protfolio from the following data:
Standard deviation of an asset 2.5%
Market standard deviation 2.0%
Risk-free are on return 13.0%
Expected return on market portfolio 15.0%
Correlation coefficient of portfolio with market 0.8
What will be the expected return on the portfolio if portfolio beta is 0.5 and the risk-free return is 10%?

Question 50

P Ltd. and Q Ltd. has an expected of 22% & 24% and standard deviation of 40% & 38% respectively. P
has a beta of 0.86 and Q 1.24. The correlation between the returns of P and Q is 0.72. The standard
deviation of the market return is 20%. Find:
a) If you invest 30% in Q and 70% in P, what is your expected rate of return and the portfolio standard
deviation?
b) What is the market portfolio's expected rate of return and how much is the risk-free rate?
c) What is the beta of portfolio if you invest 30% in Q and 70% in P?

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Question 51

You have a portfolio of the following four shares:

Share P Q R S
Investment (Rs.) 100,000 100,000 75,000 125,000
Beta 0.80 1.25 1.00 0.60

What is the expected rate of return on your portfolio if the risk-free rate of return is 9% and the expected
market rate of return is 16%?

Question 52

Following is the data regarding six securities:

A B C D E F
Return (%) 8 8 12 4 9 8
Risk (%) (Standard Deviation 4 5 12 4 5 6

i) Which of the securities will be selected?

ii) Assuming perfect positive correlation, analyze whether it is preferable to invest 75% in security A and
25% in security C or 100% in security E.

Question 53

John inherited the following securities on his uncle's death:

Types of Security Nos. Annual Coupon % Maturity Years Yield %

Bond A (Rs. 1,000) 10 9 3 12
Bond B (Rs. 1,000) 10 10 5 12
Preference Shares C (Rs. 100) 100 11 * 13*
Preference Shares D (Rs. 100) 100 12 * 13*

*likelihood of being called at a premium over par Compute the current value of his uncle's portfolio.

Question 54

The following data relating of two securities, A and B

A B
Expected Return 22% 17%
Beta factor 1.5 0.7

Assume: IRF = 10, and RM=18%

Find out whether the securities, A and B are correctly priced?

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