MAPM

1. Risk profiling and it's relationship with asset allocation decision:-

Risk profiling depends on one’s risk capacity, risk tolerance, and risk requirement. It aims to access one’s
overall general attitude towards investment risk and identify what type of investor you are.

Asset allocation, on the other hand, is an investment strategy that aims to balance risk and rewards by
adjusting one’s portfolio’s assets according to their goals, risk tolerance, risk capacity and investment
time frame.

Refer Ss

2. Capital allocation between risky and risk-free assets using CAL:-

Asset allocation is the apportionment of funds among different types of assets, such as stocks and
bonds, having different ranges of expected returns and risk.

Capital allocation, on the other hand, is the apportionment of funds between risk-free investments, such
as T-bills, and risky assets, such as stocks.

The simplest case of capital allocation is the allocation of funds between a risky asset and a risk-free
asset.

The risk-return profile of this 2-asset portfolio is determined by the proportion of the risky asset to the
risk-free asset. If this portfolio consists of a risky asset with a proportion of y, then the proportion of the
risk-free asset must be 1 – y.

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

One way to adjust the riskiness of a portfolio is by varying the proportion of the risk-free asset and the
risky asset. The investment opportunity set is the set of all combinations of the risky and risk-free assets,
which graphs as a line when plotted as return against risk, as measured by the standard deviation.

The line begins at the intercept with the minimum return and no risk of the risk-free asset, when the
entire portfolio is invested in the risk-free asset, to the maximum return and risk when the entire
portfolio is invested in the risky asset. Hence, this capital allocation line (CAL) is the graph of all possible
combinations of the risk-free asset and the risky asset.
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 the reward-to-
variability ratio because the expected return increases continually with the increase in risk as measured
by the standard deviation.

Slope of CAL = Reward-to-Variability 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.

For chart refer

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

The risk-free return is subtracted from the portfolio return to yield the proportion of the return due to
the risky asset. The increased return for the increased risk is the reward for accepting the increased risk
— the risk premium.

3. Concepts of CAL, CML, SML and Efficient Frontier:-

A. CAL:-

- A Capital Allocation Line (CAL) exists for each risky asset (or a portfolio of risky assets).

- Combinations of this risky asset (or portfolio of risky assets) and a risk-free asset lie on the CAL. –
Different from asset allocation (the allotment of funds across different types of assets with different
risks and returns).
- Capital allocation refers to the allotment of funds between risk-free assets and risky assets. The slope
of the CAL is the Sharpe ratio of the risky asset.
- Graphically, the CAL links along the return axis the risk-free rate with the expected return of an
individual asset.

- Whereby, points on the CAL left from the risk-return combination of an individual risk asset reflect the
expected risk-return from a portfolio composed of the risky asset and the risk-free asset.

- Points on the CAL right from the risk-return combination of an individual asset reflect the expected
return from a portfolio whereby the investor not only invests in the risky asset, but in addition also
borrows funds at risk-free rate to acquire even more of the very risky asset. Therefore, this reflects the
expected return from adding leverage.
B. CML:-

- The Capital Market Line (CML) is basically the CAL for the market portfolio. One may assume that in an
efficient market the market portfolio (representing the most superior portfolio available) is among all
feasible risky portfolios the one with the highest Sharpe ratio. Conceptually, it is referred to as the
portfolio comprising all financial assets one can invest in.
C. EF:-

- The risk-return combination of the market portfolio also defines the Efficient Frontier (EF). – Now, the
EF is the set of optimal portfolios of risky assets offering the highest expected return for a defined level
of risk (or: indicating the lowest risk for a given level of expected return).

- Portfolios that lie below the EF are not optimal, because they do not provide sufficient return for the
assumed level of risk.
- Such as is the case with the CAL, points on the CML left of the risk-return combination of the market
portfolio represent capital allocations whereby part is invested in the market portfolio and part in risk-
free assets. Points on the CAL right to the market portfolio represent levered portfolios.
D. SML:-

- The Security Market Line (SML) is derived from the CML displaying the expected return of an individual
security, whereby the horizontal axis for the SML represents the systematic, non-diversifiable risk –the
beta. This is different from the CML, where the horizontal axis represents the total risk of return of a
portfolio – alas: volatility or standard deviation.

4. Calculation of Portfolio Risk-return:-

Example:- To do this we must first calculate the portfolio beta, which is the weighted average of the
individual betas. Then we can calculate the required return of the portfolio using the CAPM formula.

For example: The expected return of the portfolio A + B is 20%. The return on the market is 15% and the
risk-free rate is 6%.80% of your funds are invested in A plc and the balance is invested in B plc. The beta
of A is 1.6 and the beta of B is 1.1.

Required:- Prepare the alpha table for the Portfolio (A + B)

Answer:

b(A + B) = (1.6 × .80) + (1.1 × .20)

= 1.5

R portfolio (A + B) = 6% + (15% - 6%) 1.5 = 19.50%

Alpha table

Expected return Required return Alpha value

Portfolio (A + B) 20% 19.50% 0.50%

5. Efficient Market Hypothesis: Definition, 3-forms, Levels of Information, Implications, Anomalies:-

A. Definition:-

- The efficient market hypothesis (EMH) theory states that share prices reflect all information.

- The EMH hypothesizes that stocks trade at their fair market value on exchanges.

- Proponents of EMH posit that investors benefit from investing in a low-cost, passive portfolio.

- Opponents of EMH believe that it is possible to beat the market and that stocks can deviate from their
fair market values.

B. Forms of EMH:-

1. The weak form suggests today’s stock prices reflect all the data of past prices and that no form of
technical analysis can aid investors. It additionally assumes that past information regarding price,
volume, and returns is independent of future prices.

2. The semi-strong form submits that because public information is part of a stock's current price,
investors cannot utilize either technical or fundamental analysis, though information not available to the
public can help investors.

3. The strong form version states that all information, public and not public, is completely accounted for
in current stock prices, and no type of information can give an investor an advantage on the market.

C. Implications of EMH:-

- The implication of EMH is that investors shouldn't be able to beat the market because all information
that could predict performance is already built into the stock price.

- It is assumed that stock prices follow a random walk, meaning that they're determined by today's news
rather than past stock price movements.

- It is reasonable to conclude that the market is considerably efficient most of the time.

- However, history has proved that the market can overreact to new information (both positively and
negatively). As an individual investor, the best thing you can do to ensure you pay an accurate price for
your shares is to research a company before purchasing their stock and analyze whether or not the
market appears to be reasonable in its pricing.
D. Anomalies of EMH:- Three generally accepted “anomalies” of EMH are (1) the size effect, (2) the
valuation effect and (3) the momentum effect.

1. The size effect shows that companies with smaller market capitalizations have historically
outperformed those with large market capitalizations, even after controlling for their higher risk. This
outperformance was volatile, as the chart below shows that there were many five-year periods when
large stocks actually outperformed small stocks..

2. The valuation effect shows that companies with low price/book (P/B) multiples have historically
outperformed those with higher P/B multiples.This is quite significant outperformance. Again, this
outperformance did not persist over every time period.

3. The momentum effect shows that companies that have performed the best over the past six months
to one year tend to perform better than the set of companies that have performed the worst over a
similar period.

6. Active Vs Passive Investing:-

https://www.educba.com/active-vs-passive-investing/

7. Types of Asset allocation strategies:-

https://corporatefinanceinstitute.com/resources/knowledge/strategy/asset-allocation/

8. Modern Portfolio Theory:- Markowitz optimization using Mean-Variance, Diversification,

Assumptions and Limitations

9. Asset Pricing Models:- CAPM, APT, FF 3-factor model, FFC 4-factor model

10. Concepts:-

a. Market Portfolio:-

- A market portfolio is a theoretical, diversified group of every type of investment in the world, with each
asset weighted in proportion to its total presence in the market.

- Market portfolios are a key part of the capital asset pricing model, a commonly used foundation for
choosing which investments to add to a diversified portfolio.

b. Correlation between assets:-

- Asset correlation is a measurement of the relationship between two or more assets and their
dependency.

- This makes it an important part of asset allocation because the goal is to combine assets with a low
correlation. The correlation measurement is expressed as a number between +1 and -1.

c. Risk-free portfolio:-
- A risk-free asset is one that has a certain future return—and virtually no possibility they will drop in
value or become worthless altogether.

- Risk-free assets tend to have low rates of return, since their safety means investors don't need to be
compensated for taking a chance.

- Risk-free assets are guaranteed against nominal loss, but not against a loss in purchasing power.

- Over the long-term, risk-free assets may also be subject to reinvestment risk.

d. Beta/Systematic risk:-

- Beta, primarily used in the capital asset pricing model (CAPM), is a measure of the volatility–or
systematic risk–of a security or portfolio compared to the market as a whole.

- Beta data about an individual stock can only provide an investor with an approximation of how much
risk the stock will add to a (presumably) diversified portfolio.

- For beta to be meaningful, the stock should be related to the benchmark that is used in the calculation.

(https://corporatefinanceinstitute.com/resources/knowledge/finance/systematic-risk/)

e. Volatility:-

- Volatility represents how large an asset's prices swing around the mean price - it is a statistical
measure of its dispersion of returns.

- There are several ways to measure volatility, including beta coefficients, option pricing models, and
standard deviations of returns.

- Volatile assets are often considered riskier than less volatile assets because the price is expected to be
less predictable.

- Volatility is an important variable for calculating options prices.

f. Idiosyncratic risk :-

- Idiosyncratic risk, also sometimes referred to as unsystematic risk, is the inherent risk involved in
investing in a specific asset, such as a stock.

- Idiosyncratic risk is the risk that is particular to a specific investment – as opposed to risk that affects
the entire market or an entire investment portfolio

- Factors of idiosyncratic risk:

* Operating strategies

* Financial policies
* Corporate culture

* Investment strategy

g. Total Return:-

- Total return, when measuring performance, is the actual rate of return of an investment or a pool of
investments over a given evaluation period.

- Total return includes interest, capital gains, dividends and distributions realized over a given period of
time.

h. Dividend yield:-

- The dividend yield–displayed as a percentage–is the amount of money a company pays shareholders
for owning a share of its stock divided by its current stock price.

- It is the metric that can be used to help dividend investors anticipate how much a company pays out to
shareholders in the form of dividends on an annual basis, compared to the current price of their shares.

- Dividend Yield Formula:- Dividend Yield = Annual Dividend Per Share ($) ÷ Share Price ($)

g. Holding period return:-

- The Holding Period Return (HPR) is the total return on an asset or investment portfolio over the period
for which the asset or portfolio has been held.

- The holding period return can be realized if the asset or portfolio has been held, or expected if an
investor only anticipates the purchase of the asset.

- Holding period return = Investment Appreciation + Investment Income

h. Minimum Variance Portfolio:-

- Minimum Variance Portfolio is the technical way of representing a low-risk portfolio.

- It carries low volatility as it correlates to your expected return (you're not assuming greater risk than is
necessary).

- A minimum variance portfolio is a collection of securities that combine to minimize the price volatility
of the overall portfolio. Volatility is a statistical measure of a particular security's price movement (ups
and downs).

i. Optimum risky portfolio:-

- The optimal risky portfolio is found at the point where the CAL is tangent to the efficient frontier.

- This asset weight combination gives the best risk-to-reward ratio, as it has the highest slope for CAL.
j. Optimum complete portfolio:-

- The optimal complete portfolio consists of a risk-free asset and an optimal risky asset portfolio.

k. Indifference curve:-

- An indifference curve shows a combination of two goods that give a consumer equal satisfaction and
utility thereby making the consumer indifferent.

- Along the curve the consumer has an equal preference for the combinations of goods shown—i.e. is
indifferent about any combination of goods on the curve.

- Typically, indifference curves are shown convex to the origin, and no two indifference curves ever
intersect.

l. Utility:-

Utility is a measure of relative satisfaction that an investor derives from different portfolios. We can
generate a mathematical function to represent this utility that is a function of the portfolio expected
return, the portfolio variance and a measure of risk aversion.

U = E(r) – ½Aσ2

Where

U = utility

E(r) = portfolio expected return

A = risk aversion coefficient

σ2 = portfolio variance

The utility equation shows the following:

- Utility can be positive or negative – it is unbounded.

- High returns add to utility.

- High variance reduces utility.

- Utility does not measure satisfaction but can be used to rank portfolios.

11. Investment styles:-