Name of University: Wolkite University

Name of College: College of Business and Economics

Name of Department: Accounting and Finance Program
Course Information
Course code AcFn3201
Course Title Investment and Portfolio Management
Degree Program BA Degree in Accounting and Finance
Module Project and Investment Analysis
Module no and M20 ; AcFn-M3201
code
Module
Coordinator
Lecturer Sitina A.
ETCTS Credits 3
Contact Hours 2
Course Objectives The course will enable students to understand different investment avenues and aware of
the risk return of different investment alternatives and estimate the value of securities so as
to make valuable investment decisions.
Course Description This course provides an overview of the field of investment .it explains basic concepts and
methods useful in investment. The course also tries to imitate the valuation of bond and
stocks. It also covers fundamental and technical analysis as well as portfolio construction
and portfolio managements.
WEEKS Course Contents Reading
1. Introduction to investment
1.1. What is investment
1.2. Investment alternatives
1.3. Investment companies
1.4. Security market
2. Risk and return
2.1. Return
2.2. Risk
2.3. Measuring historical risk
2.4. Measuring historical return
2.5. Measuring expected risk and return
3. Fixed income securities
a. Bond characteristic
b. Bond price
c. Bond yield
d. Risks in bond
e. Rating of bonds
f. Analysis of convertible bonds
4. Stock and equity valuation
4.1. Stock characteristic
4.2. Balance sheet valuation
4.3. Dividend discount model
4.4. Free cash flow model
4.5. Earning multiplier approach
5. Security analysis
5.1. Macro-economic analysis
5.2. Industry analysis
5.3. Company analysis
5.4. Technical analysis
6. Portfolio theory
6.1. Diversification and portfolio risk

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 6.2. Portfolio risk and return
6.3. Capital allocation between risky and risk free assets
6.4. Optimum risky portfolio
7. Portfolio Management
7.1. Portfolio performance evaluation
7.2. The process of portfolio management
7.3. Risk management and hedging
7.4. Active portfolio management
7.5. International portfolio management
Teaching & Learning The teaching and learning methodology include lecturing, discussions, problem solving,
Methods/strategy and analysis. Take-home assignment will be given at the end of each chapter for
submission within a week. Solution to the assignments will be given once assignments are
collected. Cases with local relevance will also be given for each chapter for group of
students to present in a class room. The full and active participation of students is highly
encouraged.
Assessment/ The evaluation scheme will be as follows:
Evaluation Test Test Test Quiz1 Assign Assignme Final Total
1 2 3 ment 2 nt 1
10% 10% 10% 10% 10% 10% 40% 100%
Work load in hours Hours Required
Total
Assessme Tutoria Self- Assign Advis ECTS
Hrs
Lectures Lab nts ls Studies ment ing
32 - 10 12 27 - - 81 3
Roles of the Instructor He/she will come to the class regularly on time and deliver the lecture in a well-organized
manner. Besides, at the end of each class he/she gives reading assignment for the next
class. He/she will make sure that proper assessments are given. He/she is also
responsible to give feedback for each assessment.
Roles of the students The success of this course depends on the students’ individual and collective contribution to
the class discussions. Students are expected to participate voluntarily, or will be called upon,
to contribute to set exercises and problems. Students are also expected to read the assigned
readings and prepare the cases before each class so that they could contribute effectively to
class discussions. Students must attempt assignments by their own. Proficiency in this
course comes from individual knowledge and understanding. Copying the works of others is
considered as serious offence and leads to disciplinary actions.
Text and reference Text Book:
books  Chandra, P. Investments Analysis Portfolio management. 3rd
Reference Books
 Bodie, Kane & Marcus. Investments. 4th
 Elton, E.J.&Guruber,M.J.. Modern Portfolio Theory and Investment Analysis. 5 th
 Avadhani,V.A Security Analysis and Portfolio Management. 9th

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 Chapter one:
Introduction to investment
1.1. What is investment?
An investment is the current commitment of money for a period of time in order to derive future
payments that will compensate the investor for
(1) The time the funds are committed,
(2) The expected rate of inflation, and
(3) The uncertainty of the future payments.
Investment refers to the concept of deferred consumption, which involves purchasing an asset, giving
a loan or keeping funds in a bank account with the aim of generating future returns. Various
investment options are available, offering differing risk-reward tradeoffs. An understanding of the
core concepts and a thorough analysis of the options can help an investor create a portfolio that
maximizes returns while minimizing risk exposure.

1.1.1. Investment vs. Speculation vs. Gambling

There is often some confusion between the terms investment, speculation and gambling. This
confusion is often linked with investment made in the stock market.

A speculator can be defined as someone that seeks to buy and sell in order to take advantage of market
price fluctuations. An investor is someone who holds on the securities that provide a good income or
capital gain by virtue of them being based on something of real and increasing value.

The most realistic distinction between the investor and the speculator is found in their attitude toward
market movements. The speculator's primary interest lies in anticipating and profiting from market
fluctuations. The investor's primary interest lies in acquiring and holding suitable securities at suitable
prices.
Many beginner investors often confused about the differences between investing and gambling.

Gambling is defined as, an act putting money at risk by betting on an uncertain outcome with the hope
that you might win money. In other word, gambling is an act of taking the risk of losing money in the
expectation of a desired result.

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Investing means committing money in order to earn a financial return.

The definitions seem to indicate a higher element of chance or randomness in gambling, while
investing appears to be more rational.

1.1.2. Characteristics of Investment

Investment refers to invest money in financial physical assets and marketable assets. A major
investment features such as risk, return, safety, liquidity, marketability; conceal ability, capital growth,
purchasing power, stability and the benefits.

Risk: Risk refers to the loss of principal amount of an investment. It is one of the major characteristics
of an investment. The risk depends on the following factors:

The investment maturity period is longer; in this case, investor will take larger risk.
Government or Semi Government bodies are issuing securities which have less risk.
In the case of the debt instrument or fixed deposit, the risk of above investment is less due to their
secured and fixed interest payable on them. For instance: Debentures.
In the case of ownership instrument like equity or preference shares, the risk is more due to their
unsecured nature and variability of their return and ownership character.
The risk of degree of variability of returns is more in the case of ownership capital compare to debt
capital.
The tax provisions would influence the return of risk.
Return: Return refers to expected rate of return from an investment. Return is an important
characteristic of investment. Return is the major factor which influences the pattern of investment that
is made by the investor. Investor always prefers to high rate of return for his investment.

Safety: Safety refers to the protection of investor principal amount and expected rate of return. Safety
is also one of the essential and crucial elements of investment. Investor prefers safety about his capital.
Capital is the certainty of return without loss of money or it will take time to retain it. If investor
prefers less risk securities, he chooses Government bonds. In the case, investor prefers high rate of
return investor will choose private Securities and Safety of these securities is low.

Liquidity: Liquidity refers to an investment ready to convert into cash position. In other words, it is
available immediately in cash form. Liquidity means that investment is easily realizable, saleable or
marketable. When the liquidity is high, then the return may be low. An investor generally prefers

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liquidity for his investments, safety of funds through a minimum risk and maximization of return from
an investment.

Marketability: Marketability refers to buying and selling of Securities in market. Marketability means
transferability or sale ability of an asset. Securities are listed in a stock market which are more easily
marketable than which are not listed. Public Limited Companies shares are more easily transferable
than those of private limited companies.

Conceal ability: Conceal ability is another essential characteristic of the investment. Conceal ability
means investment to be safe from social disorders, government confiscations or unacceptable levels of
taxation, property must be concealable and leave no record of income received from its use or sale.
Gold and precious stones have long been esteemed for these purposes, because they combine high
value with small bulk and are readily transferable.

Capital Growth: Capital Growth refers to appreciation of investment. Capital growth has today become
an important character of investment. It is recognizing in connection between corporation and
industry growth and very large capital growth. Investors and their advisers are constantly seeking
‘growth stock’ in the right industry and bought at the right time.

Purchasing Power Stability:-It refers to the buying capacity of investment in market. Purchasing power
stability has become one of the import traits of investment. Investment always involves the
commitment of current funds with the objective of receiving greater amounts of future funds.

Stability of Income It refers to constant return from an investment. Another major characteristic
feature of the Investment is the stability of income. Stability of income must look for different path just
as security of principal. Every investor always considers stability of monetary income and stability of
purchasing power of income.

Tax Benefits Tax benefits are the last characteristic feature of the investment. Tax benefits refer to plan
an investment program without regard to one’s status may be costly to the investor. There are actually
two problems: amount of income paid by the investment and another is the burden of income tax
upon that income.

1.1.3. Investment Activity

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Investment activity includes buying and selling of the financial assets, physical assets and marketable
assets in primary and secondary markets. Investment activity involves the use of funds or savings for
further creation of assets or acquisition of existing assets.
Financial Assets
Physical Assets
Marketable Assets from the Primary and Secondary Market
Financial Assets are: Cash, Bank Deposits, Provident Fund, Pension Scheme, Post Office Certificates and
Deposits.
Physical Assets are: House, Land, Building and Flats, Gold, Silver and other Metals, Consumer Durables
Marketable Assets are: Shares, Bonds, Government Securities, etc.
1.1.3. Classification of Investment
On the Basis of Physical Investments:House, Land, Building, Gold and Silver, Precious stones
On the Basis of Financial Investment:Financial investments further classified on the basis of:
Marketable and Transferable investments: Shares, Debentures of public limited companies, Bonds
of public sector unit, government securities, etc…
Non-Marketable Investments: Bank Deposits, Provident and Pension Funds, Insurance Certificates,
Post office Deposits, National, Saving Certificates, Company Deposits, Private Companies Shares etc.

1.2. Investment alternatives

The investors have the following investment alternatives:
A. Indirect investing: Indirect investing is the buying and selling of the shares of investment
companies which hold portfolios of securities. Examples: the assets of mutual funds which the most
popular type of Investment Company. Households also own a large, and growing, amount of
pension fund reserves, and they are actively involved in the allocation decisions of pension funds
through plans and other self-directed retirement plans.
B. Direct Investing: The investment alternatives available through direct investing involves securities
that investors not only buy and sell themselves but also have direct control over. Investors, who
invest directly in financial markets, either using a broker or by other means, have a wide variety of
assets from which to choose.

Non-marketable investment opportunities, such as savings accounts at saving institutions.

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Marketable securities may be classified into one of three categories: the money market, the capital
market, and the derivatives market.
Investors should understand money market securities, particularly Treasury bills, but they typically
will not own these securities directly, choosing instead of own them through the money market funds.
Within the capital market, securities can be classified as either fixed - income or equity securities.
Finally, investors may choose to use derivative securities in their portfolios. The market value of these
securities is derived from an underlying security such as common stock.

Securities: A security is a legal document that shows an ownership interest. Securities have historically
been associated with financial assets such as stocks and bonds, but in recent years have also been used
with real assets. Securitization is the process of converting an asset or collection of assets into a more
marketable form.

Security Groupings: Securities are placed in one of three categories: equity securities, fixed income
securities, or derivative assets.
1) Equity Securities: The most important equity security is common stock. Stock represents ownership
interest in a corporation.
2) Fixed Income Securities: A fixed income security usually provides a known cash flow with no
growth in the income stream. Bonds are the most important fixed income securities. A bond is a
legal obligation to repay a loan’s principal and interest, but carries no obligation to pay more than
this. Although accountants classify preferred stock as an equity security, the investment
characteristics of preferred stock are more like those of a fixed income security. Most preferred
stocks pay a fixed annual dividend that does not change overtime consequently.
3) Derivative Assets: is probably impossible to define universally. In general, the value of such an asset
derives from the value of some other asset or the relationship between several other assets. Future
and options contracts are the most familiar derivative assets.

1.3. Investment companies

Investment companies are financial intermediaries that collect funds from individual investors and
invest those funds in a potentially wide range of securities or other assets. Each investor has a claim to
the portfolio established by the investment company in proportion to the amount invested. These
companies thus provide a mechanism for small investors to “team up” to obtain the benefits of large-
scale investing.

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An investment company is a financial service organization that sells shares in it to the public and uses
the funds it raises to invest in a portfolio of securities such as money market instruments or stocks and
bonds.

1.3.1. Types of Investment Companies

In the United States, investment companies are classified by the Investment Company Act of 1940 as
either unit investment trusts or managed investment companies. The portfolios of unit investment
trusts are essentially fixed and thus are called “unmanaged.” In contrast, managed companies are so
named because securities in their investment portfolios continually are bought and sold: The portfolios
are managed. Managed companies are further classified as either closed-end or open-end. Open-end
companies are what we commonly call mutual funds.

Unit Investment Trusts

Unit investment trusts are pools of money invested in a portfolio that is fixed for the life of the fund. To
form a unit investment trust, a sponsor, typically a brokerage firm buys a portfolio of securities which
are deposited into a trust. It then sells to the public shares, or “units,” in the trust, called redeemable
trust certificates. All income and payments of principal from the portfolio are paid out by the fund’s
trustees (a bank or trust company) to the shareholders.

There is little active management of a unit investment trust because once established, the portfolio
composition is fixed; hence these trusts are referred to as unmanaged. Trusts tend to invest in
relatively uniform types of assets; for example, one trust may invest in municipal bonds, another in
corporate bonds. The uniformity of the portfolio is consistent with the lack of active management. The
lack of active management of the portfolio implies that management fees can be lower than those of
managed funds.

Sponsors of unit investment trusts earn their profit by selling shares in the trust at a premium to the
cost of acquiring the underlying assets. For example, a trust that has purchased $5 million of assets
may sell 5,000 shares to the public at a price of $1,030 per share, which (assuming the trust has no
liabilities) represents a 3% premium over the net asset value of the securities held by the trust. The 3%
premium is the trustee’s fee for establishing the trust. Investors who wish to liquidate their holdings of
a unit investment trust may sell the shares back to the trustee for net asset value. The trustees can

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either sell enough securities from the asset portfolio to obtain the cash necessary to pay the investor, or
they may instead sell the shares to a new investor (again at a slight premium to net asset value).

Managed Investment Companies

There are two types of managed companies: closed-end and open-end. In both cases, the fund’s board
of directors, which is elected by shareholders, hires a management company to manage the portfolio
for an annual fee that typically ranges from 2% to 1.5% of assets. In many cases the management
company is the firm that organized the fund.

Closed-End Investment Companies:

The closed-end investment company, usually sells no additional shares of its own stock after the initial
public offering. Therefore, their capitalizations are fixed, unless a new public offering is made. The
shares of a closed-end fund trade in the secondary markets (e.g., on the-exchanges) exactly like any
other stock. To buy and sell, investors use their brokers, paying (receiving) the current price at which
the shares are selling plus (less) broker age commissions.

Open-End Investment Companies (Mutual Funds):

Open-end investment companies, the most familiar type of managed company are popularly referred
to as mutual funds and continue to sell shares to investors after the initial sale of shares that starts the
fund. The capitalization of an .open-end investment company is continually changing—that is, it is
open-ended—as new investors buy additional shares and some existing shareholders cash in .by
selling their shares back to the company.

Mutual funds typically are purchased either:

1. Directly from a fund company, using mail or telephone, or at the company's office locations.
2. Indirectly from a sales agent, including securities firms, banks, life insurance companies, and
financial planners.

Mutual funds may be affiliated with an underwriter, -which usually has an exclusive right to
distribute shares to investors: Most underwriters distribute shares through broker/dealer firms.

Mutual funds are either corporations or business trusts typically formed by an investment advisory
firm that selects the/board of trustees (directors) for the company. The trustees, in turn, hire a separate

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management company, normally the investment advisory firm, to manage the fund. The management
company is contracted by the investment company to perform necessary research and to manage the
portfolio, as well as to handle the administrative chores, for which it receives a fee.

“ Major Type’s mutual funds

There are two major types of mutual funds:
1) Money market mutual funds
2) Stock (also called equity) funds and bond & income funds
These types of funds parallel of money markets and capital markets. Money market funds concentrate
on short-term investing by holding portfolios of money market assets, whereas stock funds and bond &
income funds concentrate on longer term investing by holding mostly capital market assets

1.3.2. Functions of Investment Companies

Investment companies perform several important functions for their investors:
i) Record keeping and administration. Investment companies issue periodic status reports, keeping
track of capital gains distributions, dividends, investments, and redemptions, and they may reinvest
dividend and interest income for shareholders.
ii) Diversification and divisibility. By pooling their money, investment companies enable investors to
hold fractional shares of many different securities. They can act as large investors even if any
individual shareholder cannot.
iii) Professional management. Most, but not all, investment companies have full-time staffs of security
analysts and portfolio managers who attempt to achieve superior investment results for their
investors.
iv) Lower transaction costs. Because they trade large blocks of securities, investment companies can
achieve substantial savings on brokerage fees and commissions.
While all investment companies pool the assets of individual investors, they also need to divide claims
to those assets among those investors. Investors buy shares in investment companies, and ownership is
proportional to the number of shares purchased. The value of each share is called the net asset value,
or NAV. Net asset value equals assets minus liabilities expressed on a per-share basis:

1.4. Security market

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Securities are tradable financial assets used as a proof of ownership of stocks, bonds or other
investment instruments. Security markets are the centers or arrangements that provide facilities for
buying and selling of financial claims (securities) and services. The corporations, financial institutions,
individuals, and governments trade in financial products on these markets either directly or through
brokers and dealers on organized exchanges or off exchanges.

The term "market" is sometimes used for what are more strictly exchanges, organizations that facilitate
the trade in financial securities, e.g., a stock exchange, foreign exchange or commodity exchange. This
may be a physical location (like the NYSE) or an electronic system (like NASDAQ).

In finance, financial markets facilitate:

 The raising of capital (in the capital markets)
 The transfer of risk (in the derivatives markets)
 The transfer of liquidity (in the money markets)
 International trade (in the foreign exchange markets)
 And are used to match those who want capital to those who have it.

1.4.1. Types of financial markets

The financial markets can be divided into different sub-types:
 Capital markets which consist of:
 Stock markets, which provide financing through the issuance of shares or common
stock, and enable the subsequent trading thereof.
 Bond markets, which provide financing through the issuance of bonds, and enable the
subsequent trading thereof.
 Money markets, which provide short term debt financing and investment.
 Commodity markets, which facilitate the trading of commodities.
 Derivatives markets, which provide instruments for the management of financial risk.
 Futures markets, which provide standardized forward contracts for trading products at some
future date.
 Insurance markets, which facilitate the redistribution of various risks.
 Foreign exchange markets, which facilitate the trading of foreign currencies.

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 The capital markets consist of primary markets and secondary markets. Newly issued securities are
bought or sold in primary markets. Secondary markets allow investors to sell securities that they
hold or buy existing securities.

1.4.2. Functions of Financial Markets

Financial markets provide our specialized, interdependent economy with many financial services,
including time preference, distribution of risk, diversification of risk, transactions economy,
transmutation of contractual arrangements, and financial management.

Time Preference: - Time preference refers to the value of money spent now relative to money available
for spending in the future. Businesses are frequently making decisions among short-term and long-
term uses of funds, and business executives must judge between outlays which provide a return in the
near term and those which pay off many years from now.

Risk Distribution: -The financial markets distribute economic risks. Employment and investment risks
are separated by the creation and distribution of financial securities. On a larger scale, the money and
capital markets transfer the massive risks from people actually performing the work (employment
risks) to savers who accept the risk of an uncertain return. The chance of failure for a 100 million €
mobile phones manufacturer may be divided among thousands of investors living and working all
over the world. If the mobile phones business fails, each investor loses only part of his or her wealth
and may continue to receive income from other investments and employment.

Diversification of risk: - In addition to permitting individuals to separate employment and investment

risks, the financial markets allow individuals to diversify among investments. Diversification means
combining securities with different attributes into a portfolio. Ordinarily, a diversified portfolio of
financial claims is less risky than a portfolio consisting of one or at most a handful of similar securities.
Total risk is reduced because losses in some investments are offset by gains in others. The benefits of
diversification are possible due to the existence of large, diversified financial markets where investors
may buy and sell securities with minimum transactions cost, regulatory interference, and so forth.

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 Chapter two:
Risk and return
2.1. Return
In finance, rate of return is also known as return on investment (ROI), rate of profit or also called as
return. Rate of Return is the ratio of money gained or lost generated on an investment relative to the
amount of money invested, whether realized or unrealized. The amount of money gained or lost may
be referred to as interest, profit/loss, gain/loss, or net income/net loss.

Components of Return
In financial theory, the rate of return at which an investment trades is the sum of five different
components. These are:
(1) Real Risk-Free Interest Rate- This is the rate to which all other investments are compared. It is
the rate of return an investor can earn without any risk in a world with of no inflation.

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(2) Inflation Premium- This is the rate that is added to an investment to adjust it for the market’s
expectation of future inflation. For example, the inflation premium required for a one year
corporate bond might be a lot lower than a ten year corporate bond by the same company because
investors think that inflation will be low over the short-run, but pick up in the future as a result of
the trade and budget deficits of years past.
(3) A Liquidity Premium- Thinly traded investments such as stocks and bonds in a family controlled
company require a liquidity premium. That is, investors are not going to pay the full value of the
asset if there is a very real possibility that issuer of bonds/shares will not be able to repay in a short
period of time because buyers are scarce. This is expected to compensate investors for the potential
lose the buyers. The size of the liquidity premium is the dependent upon an investor’s perception of
how active a particular market is.
(4) Default Risk Premium: Investors believe that the issuer company will default (unable to repay) on
its obligation or go bankrupt, and as a result of investors demanding a default risk premium. This is
expected to compensate investors for the potential lose of the repay.

(5) Maturity Premium: The further in the future the maturity of a company’s bonds, the greater the
price will fluctuate when interest rates change. That’s because of the maturity premium.

2.2. Measuring Returns

Returns on the investments can be seen in two ways. These are: Ex-post returns and ex-ante returns.
 Ex Post Returns: Return calculations done ‘after-the-fact,’ in order to analyze what rate of return
was earned. Ex-post return is based on historical data.
 Ex Ante Returns: Return calculations may be done ‘ before-the-fact,’ in which case; assumptions
must be made about the future. Ex-ante return forecasted returns for the future.

Measuring Historical Returns (Ex Post Returns)

Measurement of historical rates of return that have been earned on a security or a class of securities
allows us to identify trends or tendencies that may be useful in predicting the future. One of the
measurements of return is the holding period return (HPR),

Holding Period Return (HPR): The simplest measure of return is the holding period return. HPR
represents the return an investor received for holding an investment for a certain period of time. This
calculation is independent of the passage of time and incorporates only a beginning point and an

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ending point. It is important to understand the calculation and limitations of various measures. The
formula for determining the HPR is as follows:

HPR = (Ending value – Beginning value) + Income

Beginning value
or
(Sale price−Purchase price)+ Current income
HPR=
Purchase price
Capital gain/loss+ Current income
=
Purchase price
It is important to understand that the HPR is an ex-post return, i.e. a return that has already taken
place. It is sometimes known as the historical return. Another thing that you should be aware of is that
the HPR is a measurement for return ov
er a single period (i.e. 4 months, 5 years, etc.)
Example 1: Assume Mr. X has purchased 100 common shares at $25 per share, receives a 10 cents per
share dividend, and later sell the shares for $30. What is holding period return of Mr. X?

HPR = $(30 x 100) – $(25 x 100) + $(0.10 x 100)

$(25 x 100)

= $3,000 – $2,500 + $10 = 20.4%

ETB2500

It makes no difference if the holding period return is calculated on the basis of a single share or 100
shares. The holding period return is exactly the same because every term is multiplied by 100.

Has this investment done well? The answer depends on how much time passed between the purchase
and the sale. Assume, if these shares were acquired in 2003 and sold in 2013, the total gain of 20.4%
is less than what could have been earned in the bank saving account which pays 5% annual interest
rate. If, however, the stocks were purchased after 2010, the return is attractive.

Example 2: At the beginning of the year a stock was selling for birr 40 per share and at a time
AtoAbebe purchased 100 shares. Over the year the stock paid 5 per share and year-end market price
became 45. What is the return of AtoAbebe from the investment?

Dividend = 5* 100= 500

Capital gain = (45-40) * 100 =500

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 Total return = 500+500 = 1000

Percentage of return: this is summarizing returns in terms of percentage than absolute dollars. It
answers a question of how much do we get for each dollar we invest. Following the previous example
Dividend yield = Dt+1/Pt = 5/40= 12.5%
Capital gain = (Pt+1 -Pt)/Pt = (45-40)/40 = 12.5%
Total return = dividend yield + Capital gain = 12.5%+12.5%= 25%
Total percentage of return = (D t+1 + (Pt+1 -Pt))/ Pt
Total percentage of return= 5+(45-40)/40 = 25%

Average rate of return

What happen if you needed to determine the investment returns over multiple periods? In other
words, what if you are interested in the average returns of an investment over a number of quarters or
years? There are two different types’ of measures for ex post mean average returns:
(i) Arithmetic average
(ii) Geometric mean

i. Arithmetic Average Returns: The best known statistic to most people is the arithmetic average. It is
also called Arithmetic Mean. Therefore, when someone refers to the mean return they usually are
referring to the arithmetic mean unless otherwise specified. The arithmetic mean return is an
appropriate measure of the central tendency of a distribution consisting of returns calculated for a
particular time" period, such as 5 years. However, when percentage changes in value over time are
involved, as a result of compounding, the arithmetic mean of these changes can be misleading. It is
a sum of all returns divided by the total number of observations (periods).
n
∑ ri
Arithmetic Average ( AM) = i =1
n
Where: ri = the individual returns
n = the total number of observations

Example: 1). Assume the following ex-post returns of Mr. X from his investment for the three years:
Year Returns
1 20%
2 -30%
3 40%

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 Average Annual Return = (0.2 - 0.3 + 0.4) / 3 = 0.1 = 10%

2) ABC co reported a return of 10%, 12%, 14%, 8% and 6% returns form year 2000 to 2004. What is
the average return of ABC co?

ii. Geometric Mean Returns: The geometric mean return measures the compound rate of growth over
time. It is often used in investments and finance to reflect the steady growth rate of invested funds
over some past period; that is, the uniform rate at which money actually few over time per period.
Therefore, it allows us to measure the realized change in wealth over multiple periods. Geometric
mean measures the compounded growth rate over a given period. It is thus a good estimate (better
that arithmetic) for the true return over a multi-period horizon.
1
Geometric Mean (GM ) =[(1+ r 1 )(1+r 2 )(1+r 3 ). ..(1+r n )] n −1
Where:
ri = the individual returns
= the total number of observations
n
Example: 1). Assume that an investment appreciates 20% during the first year, loses 30% during the
second year, and then gains 40% during the third year.
Solution: GM = [(1+ 0.2)* (1 - 0.3)* (1+ 0.4)(1/3) –1 = [1.176](1/3) -1= 0.055 = 5.5%

2) ABC co reported a return of 10%, 12%, 14%, 8% and 6% returns form year 2000 to 2004. What is
the Geometric average return of ABC co?

Geometric Average = [(1+R1) (1+R2) ---- (1+Rn) 1/n -1

Following the above example average return will be:

= [(1.10) (1.12) (1.14) (1.08) (1.06)] 1/5 = (1.60785) 1/5 -1= 1.0996-1= 9.96%

Arithmetic Mean vs. Geometric Mean:

When should we use the arithmetic mean and when should we use the geometric mean to describe the
returns from financial assets? The answer depends on the investor's objective:

 The arithmetic mean is a better measure of average (typical) performance over single periods. It is
also used to estimate of the expected return for next period.

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 The geometric mean is a better measure of the change in wealth over the past (multiple periods). It
is a backward-looking concept, measuring the realized compound rate of return at which money
grew- over a specified period.

Measuring Expected (Ex-Ante) Returns

While past returns might be interesting, investor’s are most concerned with future returns. Sometimes,
historical average returns will not be realized in the future. Developing an independent estimate of ex
ante returns usually involves use of forecasting discrete scenarios with outcomes and probabilities of
occurrence. Ex-ante returns or forecasts made based on scenario analysis. Scenario analysis is a better
measure for short term forecasts because the current situation has large bearing on what is likely to
happen over a short period. Historical returns are a better long-term forecast.

Scenario analysis: Forecast multiple rates of return and their probabilities of occurrence. Forecasted
return is the probability weighted sum of the various rates of return. The general formula for
estimating Ex-ante (forecast) returns is presented as follows:
n
Expected Return ( ER) =∑ (r i×Prob i )
i=1

Where: ER = the expected return on an investment

Ri = the estimated return in scenario i
Probi= the probability of state ioccurring

Example 1: This is type of forecast data that are required to make an ex ante estimate of expected
return. You could forecast the following based on three state of the economy:

State of the Probability of Possible Returns on

Economy Occurrence Stock A in that State
Economic
Expansion 25.0% 30%
Normal Economy 50.0% 12%
Solution: Recession 25.0% -25%

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 n
Expected Return ( ER ) =∑ ( r i×Prob i )
i=1
=( r 1×Prob1 )+( r 2×Prob2 )+( r 3 ×Prob3 )
=( 30%×0 .25 )+( 12%×0 . 5)+( -25%×0 . 25)
=7 . 25%

(OR): Sum the products of the probabilities and possible returns in each state of the economy.

Probability of Possible Returns on Weighted Possible

State of the Economy occurrence Stock Returns on the Stock
(1) (2) (3) (4)=(2)×(3)
Economic Expansion 25.0% 30% 7.50%
Normal Economy 50.0% 12% 6.00%
Recession 25.0% -25% -6.25%
Expected Return on the Stock =7.25%

Example 2: Suppose an investor is considering an investment of 200,000 in the stock of XYZ co or ABC
co. hoping to gain dividend and selling it at appreciated price after one yr. Over the year it is
presumed that the economy will be 20% at boom, 60% at normal and 20% at recession. What is the
expected return from the investment given the following rate of returns in various economic
conditions?

Economic Probabilities Return of Return of Expected return of Expected return of

conditions XYZ ABC XYZ ABC
Boom 0.2 10% -4% 2% -0.8%
Normal 0.6 11% 20% 6.6% 12%
Recessions 0.2 26% 40% 5.2% 8%
ER 1 13.8% 19.2%

2.3. Risk
Riskis the probability of earning lesser return than the expected one or incurring loss. Risk is often
associated with the dispersion in the likely outcomes. Dispersion refers to variability. It is a chance of
unfavorable event to occur.

Risk is assumed to arise out of variability, which is consistent with our definition of risk as the chance
that the actual outcome of an investment will differ from the expected outcome. For example; if an
investor expects a 10% rate of return on a given investment, then any return less than 10% is

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considered harmful. If an asset's return has no variability, in effect it has no risk. An example on this
regard is Government treasury securities. This is basically because virtually there is no chance that the
government will fail to redeem these securities at maturity or that the treasury will default on any
interest payment owed.

When it comes to investments, there are always some levels of uncertainty associated with future
holding period returns. Such uncertainty is commonly known as the risk of the investment. Then the
question will be what causes the uncertainty (or volatility) of an investment’s returns? The answer
depends on the nature of the investment, the performance of the economy, and other factors. In other
words, when you “dissect” the uncertainty of an investment’s return, you will realize that it is made up
of different components. The following are some of the components:

(a) Business risk: This is the uncertainty regarding the earnings (or profitability) of a firm as a result
of changes in demand, input prices, and technological obsolescence.
(b) Default risk: This is the uncertainty regarding an issuing firm’s ability to pay interest, principal,
etc. on its debt instruments.
(c) Inflation risk: This is the uncertainty over future rates of inflation. If the return from an
investment is barely keeping up with the rate of inflation, an investor’s purchasing power will be
eroded as time goes on. In other words, the investor will receive a lesser amount of purchasing
power than what was originally invested because the cost of buying everything has gone up.
Inflation risk is also known as purchasing power risk.
(d) Market risk: This represents the changes in an investment’s price (or market value) as a result of
an event that affects the entire market. An example is the impact of a market correction or a
market crash on an investment’s return.
(e) Interest rate risk: This represents the fluctuation in the value of an investment when market
interest rate changes. This has a big impact on interest-paying investments because as market
interest rate rises (falls), an investor’s money is tied up in a bond that pay less (more) than the
going rate, and hence the value of the investor’s bond decreases (increases).
(f) Liquidity risk: This is the risk of not being able to sell an investment immediately with a
reasonable price.
(g) Political risk: This is caused by changes in the political environment that affect an investment’s
market value. Political risk can be classified as either domestic or foreign political risk. An

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 example of domestic political risk is a change in the tax laws, and an example of foreign political
risk is a change in a foreign government’s policy regarding capital outflow.
(h) Call-ability risk: This is the risk that an investment is recalled (or retired) prior to the original
stated date. This type of risk is most applicable to long-term bonds and preferred stocks. This
usually happens when the issuing firms find the market conditions favorable in “refinancing”
such investments.
(i) Exchange rate risk: This is the uncertainty regarding the changes in exchange rates that might
affect the value of an investment. Exchange rate uncertainty has an impact on both domestic and
foreign investments.
Broadly speaking, there are two kinds of risks that the investors will deal with:
(1) Unsystematic Risk
(2) Systematic Risk
(1) Unsystematic risk: It also called diversifiable risk, unique risk, or firm-specific risk. It is a risk that
associated to a particular security. Such as; risk created from employee strikes or management
decision change.

For example, if the asset under consideration is stock in a single company,

 The negative NPV projects will tend to decrease the value of stock.
 Unanticipated lawsuits, industrial accidents, strikes etc will decrease the FCF’s and thereby
decrease the share values.

Unsystematic risk is essentially eliminated by diversification, so a portfolio with many assets has almost
no unsystematic risk.

(2) Systematic risk: is a risk that will affect all in the same manner. Italso called as undiversifiable risk,
unavoidable risk, or market risk. It affects an overall market. Its examples are such as:
 changes in nation’s economy
 tax reforms
 change is world energy situation

These are the risks that affect securities overall (whether in a portfolio or single) and, consequently,
cannot be diversified away. An investor who holds a well-diversified portfolio will be exposed to this
type of risk.Therefore: Total Risk = Unsystematic Risk + Systematic Risk
2.4. Measuring risk

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A risk of an investment can be measured in absolute term using standard deviations and variance or in
relative terms using coefficient of variation.
Variability of returns can be measured by either of range or standarddeviation.
RANGE: Range can be used as a measure of variability (difference between the maximum and
minimum return), however it is a poor measure since it only uses 2 observations.

The range of total possible returns

on the stock A runs from -30% to
+40%. If the required return on the
stock is 10%, then those outcomes
less than 10% represent risk to this
investor.

As a rough measure of risk, range tells us that common stock is more risky than treasury bills.

Standard Deviation (σ): An absolute measure of risk

The most commonly used measure of dispersion over some time period is the standard deviation,
which measures the deviation of each observation from the arithmetic mean of the observations and is
a reliable measure of variability, because all the information in a sample is used. The standard
deviation is a measure of the total risk of an asset or a portfolio. It can be represented by “ σ”.It captures
the total variability in the assets or portfolios return whatever the source of that variability. A standard
deviation is useful to evaluate investments, which have approximately equaled in expected returns. In
other word, standard deviation is the square root of variance. Standard deviation can be calculated
based on both forecasted returns and historical returns.

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(i) Ex-post Standard Deviation
The following formula used for calculate historical Standard Deviation is:

√
n
∑ ( r i− AR )2
i =1
Ex post σ =
n−1
where: σ = the standard deviation AR = Average return
ri = possible return in time i n = number of observations

Note: To calculate the historical standard deviation, first we should have to calculate historical average
return.
EXAMPLE: Assume the following historical returns for the past four consecutive on investment of stock
A and estimate the standard deviation: 10%, 24%, -12%, 8% and 10%.
Step 1 – Calculate the Historical Average Return
n
∑ ri
10+24-12+ 8+10 40
Average Returm ( AR ) = i=1 = = =8 . 0 %
n 5 5
Step 2 – Calculate the Standard Deviation

√
n ¿
∑ ( r i−r )2
Ex-post σ =
i =1
n−1
=
√ ( 10-8 )2 +( 24−8)2 +(−12−8 )2 +( 8−8 )2 +( 14−8)2
5−1

=
√ 22 +162 −202 + 02 +22
4
=
4 √
4 +256+ 400+0+ 4
=
664
4
=√ 166=12 . 88 %
√

(ii) Estimating Ex-ante Standard Deviation

Ex-ante standard deviation can be calculated in a similar way to ex-ante returns. Scenario based
standard deviation is as below:

√
n
Ex-ante σ = ∑ ( Prob i )×(r i −ERi )2
i=1

Where: Probi= probability of scenario i

ri = possible return at scenario i

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 ERi = Expected return of the security i
Note: To calculate the Ex-ante standard deviation also, first we should have to calculate expected
return.
EXAMPLE: Assume the following possible returns on investment of stock A under three scenarios (State
of the Economy) and their respective probability of their occurrenceand estimate the standard
deviation:
State of the Possible Returns
Economy Probability on Security A
Recession 25.0% -22.0%
Normal 50.0% 14.0%
Boom 25.0% 35.0%
Solution: First, calculate expected return of stock A:
ERA = 0.25(-22%) + 0.50(14%) + 0.25(35%) = 10.3%
Then; using the formula of ex-ante standard deviation calculate it:

√
n
Ex ante σ = ∑ (Prob i )×(r i −ERi )2
i=1
= √ P1 (r 1− ER A )2 +P 2 (r 2 −ER A )2 +P3 (r 3 −ER A )2
= √. 25(−22−10 . 3)2 +.5(14−10 . 3)2 +.25 (35−10 .3 )2
= √. 25(−32. 3 )2 +. 5(3 .8 )2 +. 25(24 . 8 )2
= √. 25(. 10401)+. 5(.00141 )+.25 (.06126 )
= √. 0420
=.205=20 .5 %
Another way to calculating Ex-ante Standard Deviation is also illustrated below:
First Step: Calculating expected return of stock A.

ERA = 0.25(-22%) + 0.50(14%) + 0.25(35%) = 10.3%

Second Step: Measure the Weighted and Squared Deviations

Deviation of
Possible Weighted Possible Return Weighted and
State of the Returns on Possible from Expected Squared Squared
Economy Probability Security Returns Return Deviations Deviations
(a) (b) (c) (d)=(b)*(c) (e)=(c)-(ER) (f)=(e) 2
(g)=(f)*(b)
Recession 25.0% -22.0% -5.5% -32.3% 0.10401 0.02600
Normal 50.0% 14.0% 7.0% 3.8% 0.00141 0.00070

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Economic Boom 25.0% 35.0% 8.8% 24.8% 0.06126 0.01531
** Expected Return(ER)=10.3% Variance(σ2) =0.0420
Standard Deviation(σ) = 20.50%
Key Note: In the above table, letters in the brackets are expressed as follows:
Column (a), (b), & (c) are given.
(d)= Expected return is determined by multiplying the probabilities with the possible returns &** is the
sum of column (d).
(e)=Calculate the deviation of possible returns from the expected return.
(f)= Square those deviations from the mean.
(g)= Multiply the square deviations by their probability of occurrence.
(σ2)= The sum of the weighted and square deviations is the variance in percent squared
(σ)=The standard deviation is the square root of the variance (in percent terms).

 In general, the higher the standard deviation means the higher the variability/risk .
Example 2: Suppose an investor is considering an investment of 200,000 in the stock of XYZ co or ABC
co. hoping to gain dividend and selling it at appreciated price after one yr. Over the year it is
presumed that the economy will be 20% at boom, 60% at normal and 20% at recession. Calculate the
standard deviation given the following rate of returns in various economic conditions?
Economic Probabilities Return of Return of Expected return of Expected return of
conditions XYZ ABC XYZ ABC
Boom 0.2 10% -4% 2% -0.8%
Normal 0.6 11% 20% 6.6% 12%
Recessions 0.2 26% 40% 5.2% 8%
ER 1 13.8% 19.2%
Let us calculate the standard deviation of the above example.
The Probability distribution, can be discrete or continuous, is discrete in our example. A discrete
probability distribution has a limited number of possible outcomes while a continuous probability
distribution indicates the probability of possible outcomes.
Economic conditions Pi Ri ER (Ri-ER)2 (Ri-ER)2 * Pi
Boom 0.2 0.1 0.138 0.00144 0.0002888
Normal 0.6 0.11 0.138 0.00078 0.0004704
Recessions 0.2 0.26 0.138 0.01488 0.0029768
Variance 0.003736

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Standard deviation of XYZ co

SD = √ variance = √ 0.003736 = 0.061122827

Economic conditions Pi Ri ER (Ri-ER)2 (Ri-ER)2 * Pi
Boom 0.2 -0.04 0.192 0.053824 0.010765
Normal 0.6 0.20 0.192 0.000064 0.000038
Recessions 0.2 0.40 0.192 0.043264 0.008653
Variance 0.019456
Standard deviation of ABC co

SD = √ variance =√ 0.019456 =0.139484766

Coefficient of variation: A relative measure of risk
This is a relative measurement. It measures the standard deviation in relation to expected return. It
measures the risk per unit of expected return. So as the coefficient of variation increases, so the risk of
an asset increases.
Coefficient of variation= SD/ ER
Where: SD: standard deviation; ER: expected return
Which one of the securities is highly risky?
XYZ coefficient of variation = 6.11/13.8=0.44
ABC coefficient of variation =13.95/19.2=0.73
Since the coefficient of variation of ABC is greater than XYZ it is more risky.
2.5. Relationship between Risk and Return
The relationship among risk and return is positive which means an increase of one result an increase
to the other. For this reason is then there will be always a risk return trade off.
Required rate of return = Risk free rate of return+ Risk premium
Risk premium is a potential reward that an investor expects to receive when making a risky
investment. This is based on a theory that investors are risk averse that is they expect an average to be
compensated for the risk that they assume when making investment.
Risk fee rate of return: It is the return available on security with no risk of default.
Risk free rate of return= Real rate of return + Expected inflation premium
Real rate of return: is the return that investors would require from security having no risk of default in
a period of no expected inflation. Real rate of return is a return necessary to convince investors to
postpone current, real consumption opportunities. It is determined by the interaction of the supply of

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funds made available by savers and the demand for funds for investment. The second component of
risk fee rate of return is an inflation premium or purchasing power loss premium.
Determinants of Risk premium
It is the potential reward that an investor expects to receive when making a risky investment. And it is
a function of several different risk elements. These factors include:
Maturity risk premium
This is the return required on a security. is influenced by the maturity of the security. Generally the
longer the time to maturity, the higher the required return on the security.
The default risk premium
The more the default risk, the higher the required rate of return will be. In this regard the order of
lower risk: Treasury bills, Government bonds, High quality corporate bonds, High quality preferred
stocks, Junk bonds, High quality commons stocks and speculative common stocks are examples.
Seniority risk premium
It is the difference in securities with respect to their claim on the cash flows generated by the company
and the claim on the company’s assets in the case of default. The less senior the claims of the security
holders, the greater the required rate of return demanded by the investor in the security.
Marketability risk premium
It is the ability of the investor to buy and sell a company’s securities quickly and without a significant
loss of value.The marketability risk premium can be significant for securities that are not regularly
traded.

Business and financial risk

Business risk: is the variability in the firm’s operating earnings over time. It is influenced by many
factors including, the variability in sales, operating cost over a business cycle, the diversity of a firms;
production line, the market power of the firm, and the choice of production technology.
Financial risk: refers to the additional variability in a company’s earnings per share that result from
the use of fixed cost sources of funds, such as debt and preferred stock. Business and financial risk are
reflected in the default risk premium applied by investors to firm securities. The higher these risks are
the higher the risk premium and required rate of return on the firm’s securities.

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 CHAPTER THREE:
FIXED INCOME SECURITIES

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Fixed-income investments have a contractually mandated payment schedule. Their investment
contracts promise specific payments at predetermined times, although the legal force behind the
promise varies and this affects their risks and required returns. At one extreme, if the issuing firm does
not make its payment at the appointed time, creditors can declare the issuing firm bankrupt.

In other cases (for example, income bonds), the issuing firm must make payments only if it earns
profits. In yet other instances (for example, preferred stock), the issuing firm does not have to make
payments unless its board of directors votes to do so.

Investors who acquire fixed-income securities (except preferred stock) are really lenders to the issuers.
Specifically, you lend some amount of money, the principal, to the borrower. In return, the borrower
promises to make periodic interest payments and to pay back the principal at the maturity of the loan.

3.1. Bond characteristic

A bond is a long-term contract under which a borrower agrees to make payments of interest and
principal, on specific dates, to the holders of the bond. Investors have many choices when investing in
bonds, but bonds are classified into four main types: Treasury, corporate, municipal, and foreign. Each
type differs with respect to expected return and degree of risk.
Treasury bonds, sometimes referred to as government bonds, are issued by the federal government.
It is reasonable to assume that the federal government will make good on its promised payments, so
these bonds have no default risk. However, Treasury bond prices decline when interest rates rise,
so they are not free of all risks.
Corporate bonds, as the name implies, are issued by corporations. Unlike Treasury bonds,
corporate bonds are exposed to default risk—if the issuing company gets into trouble, it may be
unable to make the promised interest and principal payments. Different corporate bonds have
different levels of default risk, depending on the issuing company’s characteristics and on the
terms of the specific bond. Default risk is often referred to as “credit risk,” and, the larger the
default or credit risk, the higher the interest rate the issuer must pay.
Corporate bonds fall into various categories based on their contractual promises to investors. They
will be discussed in order of their seniority.

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 Secured bondsare the most senior bonds in a firm’s capital structure and have the lowest risk
of distress or default. They include various secured issues that differ based on the assets that
are pledged.
 Mortgage bondsare backed by liens on specific assets, such as land and buildings. In the case
of bankruptcy, the proceeds from the sale of these assets are used to pay off the mortgage
bondholders.
 Collateral trust bondsare a form of mortgage bond except that the assets backing the
bonds are financial assets, such as stocks, notes, and other high-quality bonds.
 Equipment trust certificatesare mortgage bonds that are secured by specific pieces of
transportation equipment, such as locomotives and boxcars for a railroad and airplanes
for an airline.
 Debenturesare promises to pay interest and principal, but they pledge no specific assets
(referred to as collateral) in case the firm does not fulfill its promise. This means that the
bondholder depends on the success of the borrower to make the promised payment.
Debenture owners usually have first call on the firm’s earnings and any assets that are not
already pledged by the firm as backing for senior secured bonds. If the issuer does not make
an interest payment, the debenture owners can declare the firm bankrupt and claim any
unpledged assets to pay off the bonds.
 Subordinated bondsare similar to debentures, but, in the case of default, subordinated
bondholders have claim to the assets of the firm only after the firm has satisfied the claims of
all senior secured and debenture bondholders. That is, the claims of subordinated bondholders
are secondary to those of other bondholders. Within this general category of subordinated
issues, you can find senior subordinated, subordinated, and junior subordinated bonds. Junior
subordinated bonds have the weakest claim of all bondholders.
 Income bondsstipulate interest payment schedules, but the interest is due and payable only if
the issuers earn the income to make the payment by stipulated dates. If the company does not
earn the required amount, it does not have to make the interest payment and it cannot be
declared bankrupt. Instead, the interest payment is considered in arrears and, if subsequently
earned, it must be paid off. Because the issuing firm is not legally bound to make its interest
payments except when the firm earns it, an income bond is not considered as safe as a

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 debenture or a mortgage bond, so income bonds offer higher returns to compensate investors
for the added risk. There are a limited number of corporate income bonds. In contrast, income
bonds are fairly popular with municipalities because municipal revenue bonds are basically
income bonds.
 Convertible bondshave the interest and principal characteristics of other bonds, with the
added feature that the bondholder has the option to turn them back to the firm in exchange
for its common stock. For example, a firm could issue a $1,000 face-value bond and stipulate
that owners of the bond could turn the bond in to the issuing corporation and convert it into
40 shares of the firm’s common stock. These bonds appeal to investors because they combine
the features of a fixed-income security with the option of conversion into the common stock
of the firm, should the firm prosper.
Because of their desirable conversion option, convertible bonds generally pay lower interest
rates than nonconvertible debentures of comparable risk.
 Zero coupon bond promises no interest payments during the life of the bond but only the
payment of the principal at maturity. Therefore, the purchase price of the bond is the present
value of the principal payment at the required rate of return. For example, the price of a zero
coupon bond that promises to pay $10,000 in five years with a required rate of return of 8
percent is $6,756.
Municipal bonds, or “munis,” are issued by state and local governments. Like corporate bonds,
munis have default risk. However, munis offer one major advantage over all other bonds: the
interest earned on most municipal bonds is exempt from federal taxes and also from state taxes if
the holder is a resident of the issuing state. Consequently, municipal bonds carry interest rates that
are considerably lower than those on corporate bonds with the same default risk. Foreign bonds
are issued by foreign governments or foreign corporations.
Foreign corporate bonds are, of course, exposed to default risk, and so are some foreign
government bonds. An additional risk exists if the bonds are denominated in a currency other than
that of the investor’s home currency. For example, if you purchase corporate bonds denominated
in Japanese yen, you will lose money even if the company does not default on its bonds if the
Japanese yen falls relative to the dollar.

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3.2. Characteristics of bonds
Although all bonds have some common characteristics, they do not always have the same contractual
features. For example, most corporate bonds have provisions for early repayment (call features), but
these provisions can be quite different for different bonds. Differences in contractual provisions, and
in the underlying strength of the companies backing the bonds, lead to major differences in bonds’
risks, prices, and expected returns. To understand bonds, it is important that you understand the
following terms.
Par Value:is the stated face value of the bond. The par value generally represents the amount of
money the firm borrows and promises to repay on the maturity date
Coupon Interest Rate:bonds require the company to pay a fixed interest each year or each six
months. When this coupon payment, as it is called, is divided by the par value, the result is the
coupon interest rate. Typically, at the time a bond is issued, its coupon payment is set at a level that
will enable the bond to be issued at or near its par
Bond quotations and prices: the price of a bond is quoted in percentage of its par value. For
example, a $5,000 par value bond quoted at 76 % would cost $3,800($5,000 x 76%).
Current Yield: is the ratio of a bond's interest payment to its current market price.
Maturity period: the number of years after which the par value is payable to the bondholders.
Selling at a discount: is selling a bond below its par value. Because bond interest payments are
fixed amounts, a bond selling at a discount will have a current yield and YTM that are larger than
its coupon rate.
Selling at premium: is selling a bond above its par value. When a bond sells at a premium, its
current yield and YTM will be less than its coupon rate.
Bond Indenture: the written agreement between corporation and the lender detailing the terms of
the debt issue.
Zero coupon bond: a bond that pays no annual interest but is sold at a discount below par, thus
providing compensation in the form of capital appreciation.

3.3. Bond Valuation

The value of any financial asset, a stock, a bond, a lease, or even a physical asset such as an apartment
building or a piece of machinery is simply the present value of the cash flows the asset is expected to
produce.

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The cash flows from a specific bond depend on its contractual features as described above. For a
standard coupon-bearing bond, the cash flows consist of interest payments plus the amount borrowed
when the bond matures. In the case of a floating rate bond, the interest payments vary over time. In the
case of a zero coupon bond, there are no interest payments, only the face amount when the bond
matures. For a “regular” bond with a fixed coupon rate, here is the situation:
i) General valuation method
n
INT Parvalue
∑ ( 1+r )t t
Value of Bond (Bo) = t =1 + (1+ r )
Or
ii) Time value formula
Bo = I(PVIFA kd,n) + M(PVIF kd,n)
Where:
Bo = the value of the bond
I = interest paid each period = Par Value x Coupon interest rate
Kd = the appropriate interest rate on the bond
n = The number of periods before the bond matures
M = the par value of the bond
(PVIF kd,n) = The present value interest factor for an annuity at interest rate of kd per period for n
1
1−
(1+k d )n
periods = kd
1
n
(PVIFkd,n) = The present value interest factor at interest rate of kd per period for n periods = ( 1+k d )

Illustration: H-Corporation sold a $1,000,000 bond issue at the beginning of 1990 in order to obtain funds
for expansion. The bonds were issued at face values of $1,000 with an original maturity of 10 years and a
coupon rate of 10%. If an investor requires a 12% rate of return on these securities, what would be the value
of these bonds to the investor in 1994? Assume the bond is to be purchased at the end of 1994 and that the
first interest payment would be received at the end of 1995.
Given: Date of issue = End of 1994
Par value =$ 1, 000
Coupon rate = 10%
Maturity Periods = 10 years
Effective interest rate = 12%

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Solution
According to the above given, H-corporation will pay $100 per year for the next ten Years. Also H-
corporation will pay the face value ( $1000) at the end of the tenth year. Thus, we estimate the market value
of the bond by calculating the present value of these cash flows separately and adding the result together.
i)Using the general valuation method.
n
INT Parvalue
∑ ( 1+r )t t
Bo = t =1 + (1+ r )
100 100 100 100 1000
1 2 3 10 10
Bo = (1 .12 ) + (1 .12 ) + (1 .12 ) +………. + (1 .12 ) + (1 .12 )
Bo = 886.99
ii) Using the time value formula
First, we calculate the present value of the annuity stream, which is $100 per year for ten years

[ ]
1
1−
(1. 12)10
Bo = 100 0 . 12 = 565.02
Second, the present value of the face value (i.e. $1000) which is going to be received at the end of the tenth
year
1000
10
Bo = (1 .12 ) = 321 .97
Then, we add the values for the two parts together to get the bond’s value.
Total bond value = 565.02 + 321.97 = 886.99
Impact of Required rate of return (RRR) on bond values - when the RRR on a bond differs from its coupon rate,
the value of a bond would differ from its par/face value. When the RRR is more than the coupon rate, the
bond value would be less than its par value that is the bond would sell at discount. Conversely, in case the RRR
is less than coupon rate, the bond value would be more than the par value that is the bond would sell at a
premium.
Consider the following example,
Given:Par value = $1,000
Coupon rate = 10%
Maturity period = 10 years

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Required - compute the value of the bond assuming the following RRR:
a) 10% b)8% c)12%
Solution

[ ]
1
1−
(1.10)10 1000
a) Po = 100
0.10 10
+ (1 .10 ) = $1,000

[ ]
1
1−
(1.08)10 1000
b) Po = 100
0.08 10
+ (1 .08 ) = $1,134

[ ]
1
1−
(1.12)10 1000
c) Po = 100
0.12 10
+ (1 .12 ) = $886.99
Thus, as you can see from the above example, an increase in interest rate will cause the prices of outstanding
bond to fall, whereas a decrease in rates will cause bond prices to rise.

3.4. Bond yield

If you examine the bond market table of The Wall Street Journal or a price sheet put out by a bond
dealer, you will typically see information regarding each bond’s maturity date, price, and coupon
interest rate. You will also see the bond’s reported yield. Unlike the coupon interest rate, which is
fixed, the bond’s yield varies from day to day depending on current market conditions. Moreover, the
yield can be calculated in three different ways, and three “answers” can be obtained. These different
yields are described in the following sections.

Yield to Maturity (YTM)

YTM is defined as the rate required in the market on a bond and is used as a basis for reaching bond
investment decisions. If the bond's price is not too far from its par value, a good first guess as the bonds
YTM is obtained by using the coupon rate as the discount rate. The intrinsic value computed making
use of the coupon rate, as a discount rate, would be the par value of the bond.YTM is the rate of return
investors earn if they buy a bond at a specific price and hold it until maturity.

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The YTM for a bond that sells at par consists entirely of an interest yield, but if the bond sells at a price
other than its par value, the YTM will consist of the interest yield plus a positive or negative capital
gains yield. Note also that a bond’s yield to maturity changes whenever interest rates in the economy
change, and this is almost daily. One who purchases a bond and holds it until it matures will receive
the YTM that existed on the purchase date, but the bond’s calculated YTM will change frequently
between the purchase date and the maturity date.
The approximate YTM can be found using the following approximation formula:
M −Bo
I+
n
M + Bo
Approximate YTM = 2

Example: Zebra Company has a Br. 1,000 par value, 10% coupon interest rate, and 15 years to
maturity. The bond is currently selling at Br. 1,090. Compute the YTM.
Solution:
Given: M = Br. 1,000; I = Br. 100 (Br. 1,000 x 10%); n = 15; Bo = Br. 1,090; YTM =?
Br . 1 ,000−Br . 1 ,090
Br .100+
15
=9 %
Br . 1 , 000+Br . 1, 090
Approximate YTM = 2
If an investor buys Zebra’s bond at Br. 1,090 and holds it for 15 years, the approximate yield or rate of
return per year is 9%.

Yield to Call
If you purchased a bond that was callable and the company called it, you would not have the option
of holding the bond until it matured. Therefore, the yield to maturity would not be earned. This would
be beneficial to the company, but not to its bondholders.

Yield to call (YTC)is the rate of return earned by an investor if he buys a bond at a specified price, Bo,
and the bond is called before its maturity date. YTC, therefore, is computed only for callable bonds. A
callable bond is a bond which is called and retired prior to its maturity date at the option of the issuer.
A bond is called by an issuer when the market interest rate falls below the coupon interest rate. The
YTC can be found by solving the following equation.

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 Call price−Bo
I+
n
Call price+ Bo
Approximate YTC = 2
Example: X Company is intending to purchase Y Company’s outstanding bond which was issued on
January 1, 1997. Y bond is a Br. 1,000 par value, has a 10% annual coupon, and a 30 year original
maturity. There is a 5-year call protection, after which time the bond can be called at 108. X
company is to acquire the bond on January 1, 1999 when it is selling at Br. 1,175.
Required: Determine the yield to call in 1999 for Y company bond.
Solution:
Given: I = Br. 100 (Br. 1,000 x 10%); Bo = Br. 1,175; call price = Br. 1,080 (Br. 1,000 x 108%);
n = 3 (call protection – 2 years elapsed since the bond was issued); YTC =?
Br . 1 ,080−Br . 1 ,175
Br .100+
3
=6 . 06 %
Br . 1 , 080+Br . 1, 175
Approximate YTC = 2
If X Company buys Y Company bond and holds the bond until the bonds are called by Y Company,
the approximate annual rate of return would be 6.06%.

Current Yield
If you examine brokerage house reports on bonds, you will often see reference to a bond’s current
yield. The current yield is the annual interest payment divided by the bond’s current price. For
example, if 1000 par bond with a 10 percent coupon were currently selling for $985, the bond’s
current yield would be 10.15 percent ($100/$985).

Unlike the yield to maturity, the current yield does not represent the return that investors should
expect to receive from holding the bond. The current yield provides information regarding the amount
of cash income that a bond will generate in a given year, but since it does not take account of capital
gains or losses that will be realized if the bond is held until maturity (or call), it does not provide an
accurate measure of the bond’s total expected return. The fact that the current yield does not provide
an accurate measure of a bond’s total return can be illustrated with a zero coupon bond. Since zeros
pay no annual income, they always have a current yield of zero. This indicates that the bond will not

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provide any cash interest income, but since the bond will appreciate in value over time, its total rate of
return clearly exceeds zero.

3.5. Risks in bond

Interest rate risk: the risk of a decline in bond’s price due to an increase in interest rate. Interest rate
risk is higher on bonds with long term maturity than on those maturing in the near future. Generally
the longer the maturity of the bond, the more its price changes in response to a given change in
interest rate. That is, the shorter the time period until a bond’s maturity, the less responsive is its
market value to a given change in interest.
Reinvestment rate: the risk that a decline in interest rate will lead to decline in income from a bond
portfolio.
An increase in interest rates will hurt bondholders because it will lead to a decline in the value of a
bond portfolio. But can a decrease in interest rates also hurt bondholders? The answer is yes, because if
interest rates fall, a bondholder will probably suffer a reduction in his or her income.
For example, consider a retiree who has a portfolio of bonds and lives off the income they produce.
The bonds, on average, have a coupon rate of 10 percent. Now suppose interest rates decline to 5
percent. Many of the bonds will be called, and as calls occur, the bondholder will have to replace 10
percent bonds with 5 percent bonds. Even bonds that are not callable will mature, and
When they do, they will have to be replaced with lower-yielding bonds. Thus, our retiree will suffer a
reduction of income.
The risk of an income decline due to a drop in interest rates is called reinvestment rate risk, and its
importance has been demonstrated to all bondholders in recent years as a result of the sharp drop in
rates
Note that interest rate risk relates to the value of the bonds in a portfolio, while reinvestment rate risk
relates to the income the portfolio produces. If you hold long-term bonds, you will face interest rate
risk, that is, the value of your bonds will decline if interest rates rise, but you will not face much
reinvestment rate risk, so your income will be stable. On the other hand, if you hold short-term bonds,
you will not be exposed to much interest rate risk, so the value of your portfolio will be stable, but you
will be exposed to reinvestment rate risk, and your income will fluctuate with changes in interest rates.

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Default risk: another important risk associated with bond is default risk, if the issuer defaults, investors
receive less than the promised return on the bond. Therefore, investors need to asses a bond’s default
rids before making a purchase. NB - the greater the default risk, the higher the bond’s yield to maturity.

3.6. Rating of bonds

Bond ratings are based on both qualitative and quantitative factors, some of which are listed below:
1. Various ratios, including the debt ratio and the times-interest-earned ratio. The better the ratios,
the higher the rating.
2. Mortgage provisions: Is the bond secured by a mortgage? If it is, and if the property has a high
value in relation to the amount of bonded debt, the bond’s rating is enhanced.
3. Subordination provisions: Is the bond subordinated to other debt? If so, it will be rated at least one
notch below the rating it would have if it were not subordinated. Conversely, a bond with other
debt subordinated to it will have a somewhat higher rating.
4. Guarantee provisions: Some bonds are guaranteed by other firms. If a weak company’s debt is
guaranteed by a strong company (usually the weak company’s parent), the bond will be given the
strong company’s rating.
5. Sinking fund: Does the bond have a sinking fund to ensure systematic repayment? This feature is a
plus factor to the rating agencies.
6. Maturity: Other things the same, a bond with a shorter maturity will be judged less risky than a
longer-term bond, and this will be reflected in the ratings.
7. Stability: Are the issuer’s sales and earnings stable?
8. Regulation: Is the issuer regulated, and could an adverse regulatory climate ause the company’s
economic position to decline? Regulation is especially important for utilities and telephone
companies.
9. Antitrust: Are any antitrust actions pending against the firm that could erode its position?
10. Overseas operations: What percentage of the firm’s sales, assets, and profits are from overseas
operations, and what is the political climate in the host countries?
11. Environmental factors: Is the firm likely to face heavy expenditures for pollution control
equipment?
12. Product liability: Are the firm’s products safe? The tobacco companies today are under pressure,
and so are their bond ratings.

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13. Pension liabilities: Does the firm have unfunded pension liabilities that could pose a future
problem?
14. Labor unrest: Are there potential labor problems on the horizon that could weaken the firm’s
position? As this is written, a number of airlines face this problem, and it has caused their ratings
to be lowered.
15. Accounting policies: If a firm uses relatively conservative accounting policies, its reported earnings
will be of “higher quality” than if it uses less conservative procedures. Thus, conservative
accounting policies are a plus factor in bond ratings.
Representatives of the rating agencies have consistently stated that no precise formula is used to set a
firm’s rating; all the factors listed, plus others, are taken into account, but not in a mathematically
precise manner. Statistical studies have borne out this contention, for researchers who have tried to
predict bond ratings on the basis of quantitative data have had only limited success, indicating that the
agencies use subjective judgment when establishing a firm’s rating

Importance of bond rating

Bond ratings are important both to firms and to investors. First, because a bond’s rating is an indicator
of its default risk, the rating has a direct, measurable influence on the bond’s interest rate and the
firm’s cost of debt. Second, most bonds are purchased by institutional investors rather than individuals,
and many institutions are restricted to investment-grade securities. Thus, if a firm’s bonds fall below
BBB, it will have a difficult time selling new bonds because many potential purchasers will not be
allowed to buy them. As a result of their higher risk and more restricted market, lower-grade bonds
have higher required rates of return, kd, than high-grade bonds.

Chapter 4: Stock and equity valuation

In finance, valuation is the process of estimating what something is worth. Items that are usually
valued are a financial asset or liability. Valuations can be done on assets (for example, investments in
marketable securities such as stocks, options, business enterprises, or intangible assets such as patents
and trademarks) or on liabilities.

Investors who are considering multiple investments or outlining an investment strategy may request
equity valuations of a company, to make the most informed investment decision. Valuation methods

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based on the equity of a company typically include a thorough analysis of cash accounts, as well as a
forecast or projection of future dividends, future earnings (revenue) and the distribution of dividends.
The total equity of a company is the sum of both tangible assets and intangible qualities. Tangible
assets include working capital, cash, inventory, and shareholder equity. Intangible qualities, or
intangible "assets," may include brand potential, trademarks and stock valuations.

There are different methods/techniques of equity valuation. The majors are:

1. Balance Sheet Valuation
2. Dividend discount model
3. Free cash flow model
4. Earning Multiplier Approach

4.1. Balance Sheet Valuation

In balance sheet valuation approach, there are four measures derived from it. These are; book value,
liquidation, replacement cost, and Tobin’s Q ratio.

Book Value Method:it is Net worth (Equity share capital plus reserve and surplus) of a company
divided by total number of outstanding equity shares. Thus this form of valuation is based on the books
of a business, where owners' equity, is determined by a simple equation of total assets minus total
liabilities and this is used to set a price. The company whose stocks sell for less than book value are
generally considered to be undervalued, or having less risk than companies selling for greater than
book value. Because most companies sell for much more than book value, a company selling for less
than book value may well have considerable upside potential. But the basic limitation of this value is
that the book value doesn’t reflect the true current economic value of the share. It also doesn’t consider
the future earnings potential of the company.

Liquidation Value Method: This approach is similar to the book valuation method, except that the
liquidation values of assets are used instead of the book value of the assets. Using this approach, the
liabilities of the business are deducted from the liquidation value of the assets to determine the
liquidation value of the business.

In simple words, the liquidation value of a company is equal to what remains after all assets have been
sold and all liabilities have been paid. Liquidation value of an equity share is calculated by dividing
liquidation value of the business by total no. of outstanding equity shares.

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Replacement Cost Method: is one of the interesting in valuing a firm is the replacement cost of its
assets less its liabilities. Some analysts believe the market value of the firm cannot get too far above its
replacement cost because, if it did, competitors would try to replicate the firm. The competitive
pressure of other similar firms entering the same industry would drive down the market value of all
firms until they came into equality with replacement cost.

Tobin’s Q: This idea is popular among economists, and the ratio of market price to replacement cost is
known as Tobin’s Q, after the Nobel Prize winning economist James Tobin. Tobin's Q Ratio is the
market value of a company's assets divided by their replacement value. Replacement value is being the
current cost of replacing the firm’s assets. In other words, the ratio of all the combined stock market
valuations to the combined replacement costs should be around one. The formula is the following:

For an individual company, the Q ratio is equal to the market price of the firm divided by its
replacement cost.

Tobin's Q Ratio = Market Capitalization / Average Total Assets

or
Q Ratio = Market Price of Firm
Replacement Cost
If individuals or companies want to enter a business, certainly it would be an important consideration
whether they could buy a business for less than what it would take to replicate the company by
starting from scratch, especially since bought out established company has revenue generation since
day one.

If the Q ratio is significantly less than 1, then it would be cheaper for potential competitors to buy the
firm rather than start a new business, so this would tend to increase its market price. If it is sold for
significantly more than the Q ratio of 1, then competitors would enter the market, and drive down the
price of the firm until it is approximately equal to 1.

As the replacement cost of a company would be difficult to ascertain quickly, the Q ratio cannot be a
driving force in determining daily stock prices for companies. However, it could be an indicator for
long-term trends and as a potential takeover target if the company’s Q ratio is less than 1.

4.2. Dividend discount model

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The most theoretically sound stock valuation method, called income valuation or the discounted cash
flow (DCF) method, involves discounting of the profits (dividends, earnings, or cash flows) the stock
will bring to the stockholder in the foreseeable future, and a final value on disposal.

Dividend valuation model is conceptually a very sound approach. According to this approach the
value of an equity share is equal to the present value of dividends expected from its ownership plus the
present value of the sale price expected when the equity share is sold.

Financial theory states that the value of a stock is the worth all of the future cash flows expected to be
generated by the firm discounted by an appropriate risk-adjusted rate. We can use dividends as a
measure of the cash flows returned to the shareholder. There are several dividend discount models
(DDMs) from all the stable model and the two-stage model are the major one.

4.2.1. Inputs into the DDM

Several inputs are required to estimate the value of an equity using the DDM.
 D1 = Dividends expected to be received in one year.
 g = Growth rate in dividends
 K = the required rate of return for the investment. The required rate of return can be estimated
using the following formula:
K= Risk-free rate + (Market risk premium x Beta).
The rate on treasury bills can be used to determine the risk-free rate. The market risk premium is the
expected return of the market in excess of the risk-free rate. Beta can be thought of as the sensitivity of
the stock compared with the market.

4.2.2. Stable Model /Constant growth DDM

The stable model is best suited for firms experiencing long-term stable growth. Generally, stable firms
are assumed to grow at the rate equal to the long-term nominal growth rate of the economy (inflation
plus real growth in GDP). In other words, the model assumes it is impossible to grow at 30% forever;
otherwise, the company would be larger than the economy.

Value of stock = D1 / K-g

If the growth rate of the firm exceeded the required rate of return, you could not calculate the value of
the stock. This is because if g > K, the result would be negative, and stocks do not have a negative
value. Another caution is that models are often very sensitive to the assumptions made regarding
growth rates, time frame, or the required rate of return.

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Finally, the dividend discount model generally understates the intrinsic value of the firm. Important
considerations such as the value of patents, brand name, and other intangible assets should be used in
conjunction with the DDM to assess the value of a firm's equity. These intangibles should be added to
the result of a DDM calculation to arrive at a more appropriate valuation.

To make the DDM practical, we need to introduce some simplifying assumptions. A useful and
common first pass at the problem is to assume that dividends are trending upward at a stable growth
rate that we will call g. Then if g = 0.05, and the most recently paid dividend was D 0 = 3.81, expected
future dividends are:
D1 = D0(1+g) = 3.81 x1.05 = 4.00
D2 = D0(1+g)2 = 3.81 x (1.05)2 = 4.20
D3 = D0(1+g)3 = 3.81 x (1.05)3 = 4.41 etc
Using these dividend forecasts in Equation, we solve for intrinsic value as:

D 0(1+ g) D 0 ( 1+ g ) 2 D 0(1+ g)3

Vo= + + +…
1+ K (1+ K)2 (1+ K )3
This equation can be simplified to:
D 0(1+ g) D 1
Vo= =
k −g k −g
Note: we divide D1 (but not D0) by k - g to calculate intrinsic value. If the market capitalization rate for
Steady State is 12%, we can use the above equation to show that the intrinsic value of a share of Steady
State stock is:
$ 4.00
V0 = =$ 57.14
0.12−0.05
The above equation is called the constant growth DDM or the Gordon model, after Myron J. Gordon,
who popularized the model. It should remind you of the formula for the present value of perpetuity. If
dividends were expected not to grow, then the dividend stream would be a simple perpetuity, and the
valuation formula for such a non growth stock would be V 0 = D1/k. As g increases, the stock price also
rises.

The constant growth DDM is valid only when g is less than k. If dividends were expected to grow
forever at a rate faster than k, the value of the stock would be infinite. If an analyst derives an estimate
of g that is greater than k, that growth rate must be unsustainable in the long run. The appropriate
valuation model to use in this case is a multistage DDM. The constant growth DDM is so widely used

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by stock market analysts that it is worth exploring some of its implications and limitations. The
constant growth rate DDM implies that a stock’s value will be greater:
(i) The larger its expected dividend per share.
(ii) The lower the market capitalization rate, k.
(iii) The higher the expected growth rate of dividends.
Another implication of the constant growth model is that the stock price is expected to grow at the
same rate as dividends. To see this, suppose Steady State stock is selling at its intrinsic value of $57.14,
so that V0 = P0. Then:
D1
Po=
k −g
Note that price is proportional to dividends. Therefore, next year, when the dividends paid to Steady
State stockholders are expected to be higher by g = 5%, price also should increase by 5%. To confirm
this, note
D2 = $4(1.05) = $4.20
P1 = D2/(k - g) = $4.20/(0.12 - 0.05) = $60.00
Note, $60.00 is 5% higher than the current price of $57.14.
To generalize:
D2 D 1 (1+ g ) D 1
P 1= = = ( 1+ g )
k−g k −g k −g
P1 = P0(1 + g)
Therefore, the DDM implies that, in the case of constant expected growth of dividends, the expected
rate of price appreciation in any year will equal that constant growth rate, g. Note that for a stock
whose market price equals its intrinsic value (V0 = P0) the expected holding period return will be
E(r) = Dividend yield + Capital gains yield
D1 P 1−P 0 D 1
¿ + = +g
P0 P0 P0

This formula offers a means to infer the market capitalization rate of a stock, for if the stock is selling
at its intrinsic value, then E(r) = k, implying that k = D1/P0 + g. By observing the dividend yield, D1/P0,
and estimating the growth rate of dividends, we can compute k. This equation is known also as the
discounted cash flow (DCF) formula. This is an approach often used in rate hearings for regulated
public utilities. The regulatory agency responsible for approving utility pricing decisions is mandated
to allow the firms to charge just enough to cover costs plus a “fair” profit, that is, one that allows a
competitive return on the investment the firm has made in its productive capacity. In turn, that return

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is taken to be the expected return investors require on the stock of the firm. The D 1/P0 + g formula
provides a means to infer that required return.

4.2.3. The Two-Stage Model

The two-stage model attempts to cross the chasm from theory to reality. The two-stage model assumes
that the company will experience a period of high-growth followed by a decline to a stable growth
period.
The first issue to deal with when using the two-stage model is to estimate how long the high growth
period should last. Should it be 5 years, 10 years, or maybe longer?

The next requirement is that the model makes an unexpected transition from high growth to slow
growth. In other words, the model assumes that the firm may be growing at 9% for five years only to
then grow at 6% (stable growth) until eternity. Is this realistic? Probably not. Most firms experience a
gradual decline in growth rates as their business matures (hence, using a three-stage dividend
discount model may be more appropriate).

Finally, just like the stable growth model, the two-stage dividend discount model is very sensitive to the
inputs used to determine the value of the equity.
Example:Assume that the first growth rate is 9% and pertains to the next five year and the second
growth rate is 6% for all years following with the current dividend of $1.30 and K=12.39%.
D0 = $1.30
K = 12.39%
g1= 9%
g2 =6%
D 0(1+ g 1) D 0 ( 1+ g 1 ) 2 D 0(1+ g 1)3 D 0(1+ g 1) 4 D 0(1+ g 1)5
P for the first five year = + + + +
1+ K (1+ K )2 (1+ K )3 (1+ K )4 (1+ K)5

D1 = $1.30 * 1.09 = $1.42

D2 = $1.42 * 1.09 = $1.54
D3 = $1.54 * 1.09 = $1.68
D4 = $1.68 * 1.09 = $1.84
D5 = $1.84 * 1.09 = $2.00
Now, we must discount the dividends by the appropriate rate to determine their present value.
P1 = $1.42 / (1.1239) = $1.26
P2 = $1.54 / (1.1239)2 = $1.22

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 P3 = $1.68 / (1.1239)3 = $1.19
P4 = $1.84 / (1.1239)4 = $1.15
P5 = $2.00 / (1.1239)5 = $1.12
P for the first five year =¿$5.94.
Next, we value the stable growth period:
D0 = $2.00 (1.06) = $2.12
K = 12.8%
g2 = 6%
$2.12 / (0.128 - 0.06) = $31.18
Next, we must calculate the present value of the dividends.
$31.18 / (1.1239)5 = $17.39
When calculating the present value of the dividends of the stable growth period, we use the same
required rate of return as the high-growth phase and raise it to the fifth power for a five-year
example like the one above. Adding the two values, we get: $17.39 + $5.94 = $23.33. Again, our result
is quite a bit lower than the current market price.

4.2.4. Problems with dividend discounting model

Problems with dividend discount models include the difficult of forecasting dividends and potential
benefits of owning a share other than dividends.

Forecasting: One problem with dividend discount models is that long term forecasting is difficult, and
the valuation is very sensitive to the inputs used: the discount rate and any growth rates in particular.
This much is true for any DCF, but a dividend discount model adds an extra layer of difficulty to the
forecasts by requiring forecasts of dividends, which means anticipating the dividend policy a company
will adopt. As with other DCF models, the discount rate is most likely to be calculated using CAPM. It
can be argued that changes to the dividend policy do not matter, as the money belongs to shareholders
however it is used. However, in this case, one might as well use a free cash flow discount valuation.

Omissions: Dividend discounts also omit cash flows other than discounts, for example:
(i) the potential benefits from a takeover bid which gives shareholders a one-off cash flow which
usually comfortably exceeds the value of the dividend stream that would be expected without
the takeover, and,
(ii) Other benefits that may be gained through having a say in the running of a company.

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This is well illustrated by the price differences between shares of different classes entitled to the same
dividends but with different voting rights.

4.3. Free cash flow model

An alternative approach to the dividend discount model values the firm using free cash flow, that is,
cash flow available to the firm or its equityholders net of capital expenditures.This approach is
particularly useful for firms that pay no dividends, for which the dividenddiscount model would be
difficult to implement. But free cash flow models may be appliedto any firm and can provide useful
insights about firm value beyond the DDM.

One approach is to discount the free cash flow for the firm (FCFF) at the weighted-averagecost of
capital to obtain the value of the firm, and subtract the then-existing value of debt to findthe value of
equity. Another is to focus from the start on the free cash flow to equity holders (FCFE), discounting
those directly at the cost of equity to obtain the market value of equity.

The free cash flow to the firm is the after-tax cash flow that accrues from the firm’soperations, net of
investments in capital and net working capital. It includes cash flowsavailable to both debt- and
equityholders.
It is given as follows:
FCFF = EBIT (1-t) + Depreciation - Capital expenditures - Increase in NWC
where
EBIT = earnings before interest and taxes
t = tax rate
NWC = net working capital
Alternatively, we can focus on cash flow available to equityholders. This will differfrom free cash flow
to the firm by after-tax interest expenditures, as well as by cash flowassociated with net issuance or
repurchase of debt (i.e., principal repayments minus proceedsfrom issuance of newdebt).
FCFE = FCFF – Interest expense x (1-t) + increase in net debt
Example:
Profit after tax 5775
Interest after tax 525.8
Change in net working 15
capital
Depreciation 3575

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Capital expenditure 6570
Increase in net debt (1000
)
FCFF 3290.
8
FCFE 1765

4.4. Earning multiplier approach

As noted, many investors prefer to estimate the value of common stock using an earnings
multipliermodel.Thereasoning for this approach recalls the basic concept that the valueof
anyinvestmentis the present valueof future returns. In the case of common stocks,the returns
thatinvestors are entitled to receive are the net earnings of the firm. Therefore, one way investors
canestimate value is by determining how many dollars they are willing to pay for a dollar ofexpected
earnings (typically represented by the estimated earnings during the following12-month period). For
example, if investors are willing to pay 10 times expected earnings, theywould value a stock they
expect to earn $2 a share during the following year at $20. You cancompute the prevailing earnings
multiplier, also referred to as the price/earnings (P/E) ratio,asfollows:
Earning multiplier = price / earning
= Current market price
Expected 12-Month earnings
The infinite period dividend discount model can be used to indicate the variables that should
determine the value of the P/E ratio as follows:
D1
p=
k −g
If we divide both sides of the equation by E(expected earnings during the next 12 months), the result is
P D 1 / E1
=
E1 K−g

Thus, the P/E ratio is determined by

1. The expected dividend payout ratio (divided by earnings)
2. The estimated required rate of return on the stock (k)
3. The expected growth rate of dividends for the stock (g)

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As an example, if we assume a stock has an expected dividend payout of 50 percent, a required rate of
return of 12 percent, and an expected growth rate for dividends of 8 percent, this would imply the
following:
D/ E = 0.50; k = 0.12; g = 0.08
0.50
P/E =
0.12−0.08
= 12.5
The spread between k and g is the main determinant of the size of the P/E ratio.

Chapter 5: Security analysis

The aim of the analysis is to determine what stock to buy and at what price, there are two basic
analysis methods; i.e. fundamental analysis and technical analysis. Fundamental analysis is the
cornerstone of investing. In fact, some would say that you are not really investing if you aren't
performing fundamental analysis. Because the subject is so broad, however, it's tough to know where
to start. There are an endless number of investment strategies that are very different from each other,
yet almost all use the fundamentals. Fundamental analysis maintains that markets may misprice a

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security in the short run but that the "correct" price will eventually be reached. Profits can be made by
trading the mispriced security and then waiting for the market to recognize its "mistake" and re-price
the security.

Technical analysis maintains that all information is reflected already in the stock price. It considers the
trends that are your friend' and sentiment changes predate and predict trend changes. Investors'
emotional responses to price movements lead to recognizable price chart patterns. Technical analysis
does not care what the 'value' of a stock is. Their price predictions are only extrapolations from
historical price patterns.

Investors can use any or all of these different but somewhat complementary methods for stock picking.
For example many fundamental investors use technical’s for deciding entry and exit points. Many
technical investors use fundamentals to limit their universe of possible stock to 'good' companies. The
choice of stock analysis is determined by the investor's belief in the different paradigms for "how the
stock market works".

5.1. Fundamental analysis

Fundamental analysis of a business/investment involves analyzing its financial statements, its
management, competitive advantages, and its competitors and markets. When applied to futures and
foreign exchange, it focuses on the overall state of the economy, interest rates, production, earnings,
and management.
Fundamental analysis is performed on historical and present data, but with the goal of making
financial forecasts. There are several possible objectives of fundamental analysis. These are:
i) To conduct a company stock valuation and predict its probable price evolution,
ii) To make a projection on its business performance,
iii) To evaluate its management and make internal business decisions,
iv) To calculate its credit risk.
Components of Fundamental Analysis:
Economic analysis;
Industry analysis and
Company analysis
5.1.1. Economic analysis
The economy is study to determine if overall conditions are good for the stock market. Is inflation a
concern? Are interest rates likely to rise or fall? Are consumers spending? Is the trade balance

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 favorable? Is the money supply expanding or contracting? These are just some of the questions that the
fundamental analyst would ask to determine if economic conditions are right for the stock market.

The macro-economy is the overall economy environment in which all firms operate. The key
variables/factors commonly used to describe the state of the macro-economy are:
 Growth rate of gross domestic product
 Industrial growth rate
 Agriculture and monsoons
 Savings and investments
 Government budget and deficit
 Price level and inflation
 Interest rate
 Balance of payment, foreign exchange reserves, and exchange rate
 Infrastructure facilities and arrangements sentiments

5.1.2. Industry analysis

Industry analysis is a market assessment tool designed to provide a business with an idea of the
complexity of a particular industry. Industry analysis involves reviewing the economic, political and
market factors that influence the way the industry develops. Major factors can include the power
wielded by suppliers and buyers, the condition of competitors, and the likelihood of new market
entrants.

Industry analysis is a market strategy tool used by businesses to determine if they want to enter a
product or service market. Company management must carefully analyze several aspects of the
industry to determine if they can make a profit selling goods and services in the market. Analyzing
economic factors, supply and demand, competitors, future conditions and government regulations will
help management decide whether to enter an industry or invest money elsewhere.

a) Economic Factors:Ecx
b) onomic factors of industry analysis include raw materials, expected profit margins and the
interference of substitute goods. The cost of raw materials is an important factor in industry analysis
because over-priced goods will not sell in an established market. Profit margins are closely linked to
materials costs because offering discounts or sales prices will shrink company profits and lessen cash
inflows for future production activity. Substitute goods allow consumers to purchase a cheaper good
that performs relatively like the original item.

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c) Supply and Demand:A supply and demand analysis helps management understand if enough
consumers are willing to purchase more goods in an industry. If demand is high and supply is low, a
company may be willing to enter the market and offer goods near the market price to gain a
competitive advantage in the industry. A trend of declining demand indicates an industry that is
oversold, and any new competitors will likely lose money because consumers are not interested in
current goods or services.
d) Competitors:The number of competitors is an important factor for proper industry analysis. If few
competitors exist in a market, they may be charging consumers higher prices because of limited
availability of products or services. As new competitors enter the market, existing companies can
lower prices to maintain their current market share; newer competitors may not be able to match
these price cuts if their products costs are too high. As industries contract, inefficient producers are
forced out.
e) Future Conditions: While no company managers can predict the future of an industry, they can try to
determine where the industry is in the business cycle. If the industry is in an emerging market stage,
companies can enter an industry and expect to earn a profit from rising consumer demand. If the
industry is in a plateau stage, then only the most efficient producers with the lowest costs can continue
to earn profits. At the end of a business cycle, demand is declining and producers leave the industry for
more profitable markets.
f) Government Regulations: Some industries have heavier regulations or taxes than others, which must
be considered by companies looking to enter new markets. Taxes and other government fees add to the
cost of doing business, which eats into profits earned by companies. Properly understanding the
amount of government regulation in an industry helps management to determine if expected profit
margins will earn a high enough return to cover these costs.

Techniques for evaluating relevant Industry Factors

Each industry has differences in terms of its customer base, market share among firms, industry-wide
growth, competition, regulation and business cycles. Learning about how the industry works will give
an investor a deeper understanding of a company's financial soundness.

i) Customers Base: Some companies serve only a handful of customers, while others serve millions. In
general, it's a red flag (a negative) if a business relies on a small number of customers for a large
portion of its sales because the loss of each customer could dramatically affect revenues.

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ii) Market Share: Understanding a company's present market share can tell volumes about the
company's business. The fact that a company possesses an 85% market share tells you that it is the
largest player in its market by far. Furthermore, this could also suggest that the company possesses
some sort of "economic moat," in other words, a competitive barrier serving to protect its current
and future earnings, along with its market share. Market share is important because of economies
of scale. When the firm is bigger than the rest of its rivals, it is in a better position to absorb the
high fixed costs of a capital-intensive industry.
iii) Industry Growth: One way of examining a company's growth potential is to first examine whether
the amount of customers in the overall market will grow. This is crucial because without new
customers, a company has to steal market share in order to grow. In some markets, there is zero or
negative growth, a factor demanding careful consideration. For example, a manufacturing
company dedicated solely to creating audio compact cassettes might have been very successful in
the '70s, '80s and early '90s. However, that same company would probably have a rough time now
due to the advent of newer technologies, such as CDs and MP3s. The current market for audio
compact cassettes is only a fraction of what it was during the peak of its popularity.
iv) Competitions: Simply looking at the number of competitors goes a long way in understanding the
competitive landscape for a company. Industries that have limited barriers to entry and a large
number of competing firms create a difficult operating environment for firms. One of the biggest
risks within a highly competitive industry is pricing power. This refers to the ability of a supplier to
increase prices and pass those costs on to customers. Companies operating in industries with few
alternatives have the ability to pass on costs to their customers. A great example of this is Wal-
Mart. They are so dominant in the retailing business, that Wal-Mart practically sets the price for
any of the suppliers wanting to do business with them. If you want to sell to Wal-Mart, you have
little, if any, pricing power.
v) Regulation: Certain industries are heavily regulated due to the importance or severity of the
industry's products and/or services. As important as some of these regulations are to the public,
they can drastically affect the attractiveness of a company for investment purposes.

In industries where one or two companies represent the entire industry for a region (such as utility
companies), governments usually specify how much profit each company can make. In these
instances, while there is the potential for sizable profits, they are limited due to regulation.

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In other industries, regulation can play a less direct role in affecting industry pricing. For example, the
drug industry is one of most regulated industries. And for good reason no one wants an ineffective
drug that causes deaths to reach the market.

5.1.3. Company analysis

At the final stage of fundamental analysis, the investor analyzes the company. The Company is one's
perception of the state of a company - it cannot necessarily be supported by hard facts and figures. A
company may have made losses consecutively for two years or more and one may not wish to touch its
shares - yet it may be a good company and worth purchasing into. There are several factors one
should look at this analysis:
Which company has performed well in comparison with other similar companies?
Which company is performing well in comparison to earlier years?
Which company is better by its management, policies, location and labor relations?
Which company is the market leader by its productions and segment?
5.1.3.1. Objectives of Company analysis
Company analysis focuses on finding attractive firms by:
a) Analyzing individual firms.
b) Understanding each firm's strengths and risks.
c) Identifying attractive firms with superior management and strong performance (measured
by sales and earnings growth).
Stock selection focuses on finding attractive stocksby:
a) Computing each stock’s intrinsic value.
b) Comparing the intrinsic value to the stock’s market price.
c) Identifying attractive stocks, which are substantially undervalued.

5.1.3.2. Significant Factors to be Considered for Company Analysis

It is imperative that one completes the politico economic analysis and the industry analysis before a
company is analyzed because the company's performance at a period of time is to an extent a
reflection of the economy, the political situation and the industry. The different issues regarding a
company that should be examined are:

1. The Management: The single most important factor one should consider when investing in a
company and one often never considered is its management. It is upon the quality, competence and

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 vision of the management that the future of company rests.A good, competent management can
make a company grow while a weak, inefficient management can destroy a successful company.

2. The Annual Report: The primary and most important source of information about a company is its
Annual Report. By law, this is prepared every year and distributed to the shareholders.The Annual
Report is broken down into the following specific parts:

a) The Director's Report: The Director’s Report is a report submitted by the directors of a company
to its shareholders, advising them of the performance of the company under their stewardship

b) The Auditor's Report: The auditor represents the shareholders and it is his duty to report to the
shareholders and the general public on the stewardship of the company by its directors.
Auditors are required to report whether the financial statements presented do, in fact, present a
true and fair view of the state of the company.

c) The Financial Statements: The published financial statements of a company in an Annual

Report consist of its Balance Sheet and other statements.

3. Ratios: No person should invest in a company until he has analyzed its financial statements and
compared its performance in the previous years, and with that of other companies.This can be
difficult at times because:
(a) The size of the companies may be different.
(b) The composition of a company's balance sheet may have changed significantly.

Ratios can be broken down into four broad categories:

a) Profit and Loss Ratios: These show the relationship between two items or groups of items in a profit
and loss account or income statement. The more common of these ratios are:
1. Sales to cost of goods sold.
2. Selling expenses to sales.
3. Net profit to sales and
4. Gross profit to sales.
b) Balance Sheet Ratios:these deals with the relationship in the balance sheet such as:
(i) Shareholders’ equity to borrowed funds.
(ii) Current assets to current liabilities.

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 (iii) Liabilities to net worth.
(iv)Debt to assets and
(v) Liabilities to assets
c) Balance Sheet and Profit and Loss Account Ratios : These relate an item on the balance sheet to
another in the profit and loss account such as:
1. Earnings to shareholder's funds.
2. Net income to assets employed.
3. Sales to stock.
4. Sales to debtors and
5. Cost of goods sold to creditors.
d) Financial Statements and Market Ratios:These are normally known as market ratios and are arrived
at by relation financial figures to market prices:
1. Market value to earnings and
2. Book value to market value.

These ratios have been grouped into eight categories that will enable an investor to easily determine
the strengths or weaknesses of a company. Market value, Earnings, Profitability, Liquidity, Leverage,
Debt Service Capacity, Asset-Management/Efficiency, and Margin

It must be ensured that the ratios being measured are consistent and valid. The length of the periods
being compared should be similar. Large non-recurring income or expenditure should be omitted
when calculating ratios calculated for earnings or profitability, otherwise the conclusions will be
incorrect.

Ratios do not provide answers. They suggest possibilities. Investors must examine these possibilities
along with general factors that would affect the company such as its management, management
policy, government policy, the state of the economy and the industry to arrive at a logical conclusion
and he must act on such conclusions.

4. Cash flow Analysis: In cash flow analysis, investors must always checks; how much is the
company's cash earnings? How is the company being financed and using it?The answers to these
questions can be determined by preparing a statement of sources and uses of funds . A statement of
sources and uses begins with the profit for the year to which are added the increases in liability

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 accounts (sources) and from which are reduced the increases in asset accounts (uses). The net
result shows whether there has been an excess or deficit of funds and how this was financed.

5.1.3.4. Company Analysis using the Relative Valuation Approach

The relative valuation approach of company analysis involves three steps:
i. Estimate future earnings per share (EPS) for the company.
ii. Estimate an earnings multiplier (P/E ratio) for the company.
iii. Therefore the future stock value is estimated as EPS x P/E ratio.

i. Estimate the EPS

Expected earnings per share are a function of the sales forecast and the estimated profit margin. Time-
series analysis is often used here.

Company sales forecast: It includes an analysis of the relationship of company sales to various relevant
economic series and to the company's industry series.
Profit margin estimate: You need to identify and evaluate the firm's Specific competitive strategy - e.g.
low-cost (the firm seeks to become the low-cost producer in the industry)? Differentiation (the firm
seeks to identify itself as unique in some attributes that are important to the customers)?
Internal performance: Relationship with its industry, which should indicate whether the company's
past performance is attributable to its industry or if it is unique to the firm.

EPS = (Sales x Net Profit Margin)/Number of Outstanding Shares

ii. Estimate the P/E

Assuming a firm has constant dividend growth rate, the value of its stock is determined by P = D 1/(k-g).
Therefore the firm's P/E ratio is: P/E = Payout ratio / (k - g), where the payout ratio is D1/EPS.

Analysts can use two approaches here, as in the industry analysis:

a) Macro analysis: Estimate a P/E ratio from the relationship among the firm, its industry and the
market.

 Identify the projected P/E multiples of the market and the industry.
 Use time-series analysis to examine the relationship among the P/E ratios for the firm, the
industry and the market.

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  Estimate the firm’s P/E ratio by adjusting the market or industry P/E multiple upwards or
downwards.
b) Micro analysis: estimate a multiplier based on three components:

 The dividend payout ratio (based on the firm’s dividend payout history, investment plans,
industry trend and current economic events).
 The required rate of return: consider fundamental factors and market-determined risk (beta)
based on CAPM.
 The rate of growth: use DuPont model.

5.2. Technical analysis

While fundamental analysis helps you decide what companies you may want to invest in; i.e. based on
the company's management, products and services, financial records, and other information. And it
won't always help you figure out when to buy, sell or hold . There will be times when the stock of a
solid company falters and times when a riskier company performs well. As a result, although
fundamental analysis is important, it's not always sufficient to make investment decisions. Technical
analysis, the study of price movements and trends, can help you figure out when to enter and exit the
market.

Technical analysts base trading decisions on examinations of prior price and volume data to determine
past market trends from which they predict future behavior for the market as a whole and for
individual securities. Several assumptions lead to this view of price movements. In technical analysis,
charts are similar to the charts that you see in any business setting. I.e. The foundation of technical
analysis is the chart. A chart is simply a graphical representation of a series of prices over a set time
frame.

Technical analysis is one of the oldest techniques used to make market decisions. Based on the ideas of
Charles Dow, technical analysts use a variety of technical indicators, or series of data points plotted on
a price chart that has been formed using price or price & volume statistics for a particular security
over a particular time period. The goal is to spot market trends and manage risks associated with price
movements.

While some indicators use complex formulas and others are simpler, all of them seek to establish
visual patterns that make sometimes confusing price data easier to understand and interpret.

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Indicators can be applied to stock, indexes, futures contracts and any other tradable instruments
whose prices move in response to supply and demand.

While each indicator depicts patterns made by the price movements of securities, studying just one
may not give you a complete picture of the direction the price is likely to head. For example, an
indicator may make false signals, called whipsaws, where prices move in one direction and quickly
revert to an original trajectory. Examining more than one study makes it easier to spot true signals.

5.2.1. Assumptions of Technical analysts

Technical analysts base trading decisions on examinations of prior price and volume data to
determine past market trends from which they predict future behavior for the market as a whole and
for individual securities. Several assumptions lead to this view of price movements:

i) The market value of any good or service is determined solely by the interaction of supply and
demand.
ii) Supply and demand are governed by numerous rational and irrational factors. Included in
these factors are those economic variables relied on by the fundamental analyst as well as
opinions, moods, and guesses. The market weighs all these factors continually and
automatically.
iii) Disregarding minor fluctuations, the prices for individual securities and the overall value of
the market tend to move in trends, which persist for appreciable lengths of time.
iv) Prevailing trends change in reaction to shifts in supply and demand relationships. These shifts,
no matter why they occur, can be detected sooner or later in the action of the marketitself.

5.2.2. The Top Five Strengths of Technical Analysis

Technical analysis involves the use of charts and technical indicators to predict the price movement of
a currency. Many people (called technicians) swear by this approach to price forecasting while others
(called fundamentalists) won’t touch it. Most traders know that technical analysis has its advantages
and strong points, but that it also has limitations. Many foreign exchange (Forex) traders use charting
methods alone while others use a combination of approaches. Let’s examine the benefits of technical
analysis.
i) Technical analysis focuses on price movement. .

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 ii) Trends are easily found.
iii) Patterns are easily identified.
iv) Charting is quick and inexpensive.
v) Charts provide a plenty of information

5.2.3. Limitations of Technical Analysis

 The same tools for everyone:-With the democratization of information, most market players use
technical analysis software that relies on the same mathematical models.

 Lack of hindsight and reflection: -Monitoring the trend is an imperative, it follows a succession of
phases of increase or decrease manic, totally disconnected with the underlying reality.

 The classical figures do not work : - The sense of the individual manager is an afterthought because
"the market is always right" one is always wrong all cons.

 The volatility has taken over :-The volatility, the most senior-and-down of each session, has
exploded since January. It induces changes daily to a breadth of 5 to 8 times higher than the
average.

5.2.4. Technical Indicator

Technical indicators, collectively called "technicals", are distinguished by the fact that they do not
analyze any part of the fundamental business, like earnings, revenue and profit margins. Technical
indicators are used most extensively by active traders in the market, as they are designed primarily for
analyzing short-term price movements. To a long-term investor, most technical indicators are of little
value, as they do nothing to shed light on the underlying business. The most effective uses of technical
for a long-term investor are to help identify good entry and exit points for the stock by analyzing the
long-term trend. In the context of technical analysis, an indicator is a mathematical calculation based
on a securities price and/or volume. The result is used to predict future prices. Common technical
analysis indicators are the moving average convergence-divergence (MACD) indicator and the
relative strength index (RSI).

In an economic context, an indicator could be a measure such as the unemployment rate, which can
be used to predict future economic trends. Common general economic indicators are the
unemployment rate, new housing starts and the consumer price index (CPI).

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5.2.4.1. Moving Average Convergence
The moving average convergence divergence (MACD) is one of the most well known and used
indicators in technical analysis. This indicator is comprised of two exponential moving averages,
which help to measure momentum in the security. The MACD is simply the difference between these
two moving averages plotted against a centerline. The centerline is the point at which the two moving
averages are equal. Along with the MACD and the centerline, an exponential moving average of the
MACD itself is plotted on the chart. The idea behind this momentum indicator is to measure short-
term momentum compared to longer term momentum to help signal the current direction of
momentum.

MACD= (Shorter-term Moving Average) – (Longer Term Moving Average)

When the MACD is positive, it signals that the shorter term moving average is above the longer-term
moving average and suggests upward momentum. The opposite holds true when the MACD is
negative - this signals that the shorter term is below the longer and suggest downward momentum.
When the MACD line crosses over the centerline, it signals a crossing in the moving averages. The
most common moving average values used in the calculation are the 26-day and 12-day exponential
moving averages. The signal line is commonly created by using a nine-day exponential moving
average of the MACD values. These values can be adjusted to meet the needs of the technician and the
security. For more volatile securities, shorter term averages are used while less volatile securities
should have longer averages.

Another aspect to the MACD indicator that is often found on charts is the MACD histogram. The
histogram is plotted on the centerline and represented by bars. Each bar is the difference between the
MACD and the signal line or, in most cases, the nine-day exponential moving average. The higher the
bars are in either direction, the more momentum behind the direction in which the bars point.

5.2.4.2. Relative Strength Index

The relative strength index (RSI) is another one of the most used and well-known momentum
indicators in technical analysis. RSI helps to signal overbought and oversold conditions in a security.
The indicator is plotted in a range between zero and 100. A reading above 70 is used to suggest that a
security is overbought, while a reading below 30 is used to suggest that it is oversold. This indicator

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helps traders to identify whether a security’s price has been unreasonably pushed to current levels and
whether a reversal may be on the way.

Figure: RSI Values

The standard calculation for RSI uses 14 trading days as the basis, which can be adjusted to meet the
needs of the user. If the trading period is adjusted to use fewer days, the RSI will be more volatile and
will be used for shorter term trades

5.2.5. Evaluation of Technical Analysis

While there are several ways those Forex traders to predict price movement, they belong to one of
three kinds of traders. They are either from the school of Technical analysis, fundamental analysis or
they make apply of both disciplines. While Forex trading can be carried out successfully with the
utilization of just one type of analysis, those that have a basic comprehend of both technical in
addition to fundamental analysis tend to be better equipped.

The foundation of technical analysis is based on volume, price along with past market data to establish
currency along with future price movements. Strict technical traders put their faith purely on these
factors with no consideration to external factors.

Yet, the way the charts are viewed and the Forex indicators employed for such an analysis are very
extensive. Technical analysis also includes support along with resistance, daily pivots, trend lines in
addition to pattern formations.

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External factors such as economic data plus political news are not factored in. Trend lines in addition
to the methods employed to spot them play a huge part in technical analysis. A lot of effort as well as
Forex indicators in addition to tools are used to verify the continuation or reversal of the current trend.
Because technical traders respond to any change in the trend line, they generally open more trades
than long term fundamental traders do. They are usually composed of midterm along with short term
traders. Having said that scalpers can make use of both disciplines plus end up opening huge amounts
of trades every week. Scalping is a topic for another day however.

Technical analysis is employed by the vast majority of traders in any financial market today. The
reasons for this are straightforward. This is the case simply because technical analysis is easier to
comprehend in addition to employ that fundamental analysis. The trader does not need a good
understanding of economics.

Technical analysis appears to be a highly controversial approach to security analysis. It has its ardent
votaries; it has its severe critics. The advocates of technical analysis offer the following interrelated
arguments in support of their position.

1. Under the influence of crowd psychology, trends persist for quite some time. Tools of
technical analysis that help in identifying these trends early are helpful aids in investment
decision making.
2. Shifts in demand and supply are gradual rather than instantaneous. Technical analysis helps
in detecting these shifts rather early and hence provides clues to future price movements.
3. Fundamental information about a company is absorbed and assimilated by the market over a
period of time. Hence, the price movement tends to continue in more or less the same
direction till the information is fully assimilated in the stock price.
4. Charts provide a picture of what has happened in the past and hence give a sense of volatility
that can be expected from the stock. Further, the information on trading volume which is
ordinarily provided at the bottom of a bar chart gives a fair idea of the extent of public
interest in the stock.

The detractor of technical analysis believes that technical analysis is a useless exercise. Their
arguments run as follows:

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 1. Most technical analysts are not able to offer convincing explanations for the tools employed by
them.
2. Empirical evidence in support of the random walk hypothesis cast its shadow over the
usefulness of technical analysis.
3. By the time an uptrend or downtrend may have been signaled by technical analysis, it may
already have taken place.
4. Ultimately, technical analysis must be a self defeating proposition. As more and more people
employ it, the value of such analysis tends to decline.
5. The numerous claims that have been made for different chart patterns are simply untested
assertions.
6. There is a great deal of ambiguity in the identification of configurations as well as trend lines
and channels on the charts. The same can be interpreted differently.

To sum up, we are in a state where the market is either poised to recover, or go into a long term
decline (a change in the major trend). A failure of the head-and-shoulders formation in the National
Index, which could occur if the index clambers over 1,400 would be a good signal to suggest a market
recovery, while a breakdown below the support levels given for the leading Sensex stocks would
suggest harsher times ahead.

Despite these limitations charting is very popular. Why? It appears that charting appeals to a certain
type of personality; the collector. Listening to a chart list describe the satisfaction he derives from
sitting down after dinner with his charts for a few hours, one is reminded of the philatelist or
lepidopterist. Finding a certain pattern gives chart lists satisfaction that transcends the possibilities of
turning the patterns into money. John Magee, the guru of chart lists writes, ecstatically about the
wonderful world of the logarithmic spirals (which) contains so much of beauty and so much of the
sheer wonder of pattern and rhythm.

A pure chartist is almost monk-like in dedication, believing the essential truth about the market is to
be found in squiggles and figures on graph paper. He is unmoved by a plant explosion or a profit
explosion. A pure chartist believes what is my position on the practical utility of technical analysis? I
believe that in a rational well-ordered and efficient market, technical analysis is a worthless exercise.
However, given the imperfections, inefficiencies and irrationalities that characterize real world
markets, technical analysis can be helpful. But I do not believe it can be of great value. Hence, it may

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be used, albeit to a limited extent, in conjunction with fundamental analysis to guide investment
decision making.

5.2.6. General Steps to TechnicalEvaluation

Many technicians employ a top-down approach that begins with broad-based macro analysis. The
larger parts are then broken down to base the final step on a more focused/micro perspective. Such an
analysis might involve three steps:
i) Broad market analysis through the major indices; such as the S&P 500, Dow Industrials,
NASDAQ and NYSE Composite.
ii) Sector analysis to identify the strongest and weakest groups within the broader market.
iii) Individual stock analysis to identify the strongest and weakest stocks within select groups.

The beauty oftechnicalanalysis lies in its versatility. Because the principles oftechnicalanalysis are
universally applicable, each of the analysis steps above can be performed using the same theoretical
background. You don't need an economics degree to analyze a market index chart. You don't need to
be a CPA to analyze a stock chart. Charts are charts. It does not matter if the time frame is 2 days or 2
years. It does not matter if it is a stock, market index or commodity. The technical principles of
support, resistance, trend, trading range and other aspects can be applied to any chart. While this may
sound easy, technicalanalysis is by no means easy. Success requires serious study, dedication and an
open mind.

Chapter 6: Portfolio theory

In finance context, a portfolio is a collection of securities that are combined and considered as a single
asset. In other word, portfolio is defined as a combination of financial assets such as stocks, bonds and
cash equivalents held by an investor. Combining assets into a portfolio has risk-reducing
effects.Modern portfolio theory proposes that securities should be managed within a portfolio (instead
of individually) for this reason. Portfolio theory is a theory that explains how the risk-averse investors
can construct portfolios that optimize expected return based on given level of market risk,

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emphasizing that risk is an inherent part of higher return. According to modern portfoliotheory, it is
possible to construct an efficient frontier of optimal portfolios.

Most investors do not hold financial securities in isolation. Instead, they prefer to hold a portfolio of
several securities. Then, a portion of an individual stock's risk can be eliminated, i.e., diversified away.
Combining different securities into portfolios is done to achieve diversification.

Diversification has two faces:

(i) Diversification results in an overall reduction in portfolio risk (return volatility over time)
with little sacrifice in returns, and
(ii) Diversification helps to immunize/vaccinate the portfolio from potentially catastrophic events
such as the complete failure of one of the constituent investments.
If only one investment is held, and the issuing firm goes bankrupt, the entire portfolio value and
returns are lost. If a portfolio is made up of many different investments, the outright failure of one is
more than likely to be offset by gains on others, helping to make the portfolio immune to such events.

6.1. Portfolio Risk and Return

The risk-return characteristic of the portfolio is obviously different from the characteristics of the
assets that makeup that portfolio, especially with regard to risk. By recalling what we have been
discussed earlier regarding the calculation of the expected return, variance, and standard deviation of
an individual security; let us see computation risk and return of the portfolio, in this section.

6.1.1. Expected Return of Portfolio

The expected return on any portfolio is easily calculated as a weighted average of the individual
securities expected returns. The percentage of a portfolio’s total value which is invested in each asset is
known as portfolio weights, which will denote by Wi. The combined portfolio weights are assumed to
sum to 100 percent of total investable funds, or 1.0, indicating that all portfolio funds are invested.
That is, wA + wB + … + wn = 1 or 100%

In other word, the expected return of a portfolio is the weighted average of the returns of the
individual assets that make up the portfolio. A formula to calculate expected return of a portfolio is
presented as follows:
n
ER p =∑ ( wi ×ERi )
i =1

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Where: ERp = the expected return on the portfolio,
ERi = the expected return of stock i.
wi = the proportion (weight ) of the portfolio invested on stock i, and

In simple:
 For two assets portfolio:ERP = (WA x ERA) + (WB x ERB)
 For three assets portfolio:ERP = (WA x ERA) + (WB x ERB) + (WC x ERC)
 For n number of assets:ERP = (WA x ERA) + (WB x ERB) + (WC x ERC) + ….. (Wn x ERn)
The portfolio weight of a particular security is the percentage of the portfolio’s total value that is
invested in that security. The sum of all securities weights is equal to 1.

Example 1: Suppose that Mr. Tola invested his 7,000 Birr on two stocks; specifically, ETB 2,000 on
stock ‘A’ and ETB 5,000 on the stock ‘B’. Again assume that the expected return from stock ‘A’ is 14%
and expected return of stock ‘B’ is 6%. Considering these information, calculated the expected return
of the portfolio.
Given:
ERA = 14%, ERB = 6%,
wA = weight of security A = ETB2,000 / ETB7,000 = 0.28 = 28.6%
wB = weight of security B = ETB5,000 / ETB7,000 = 0714 = 71.4% or it is (1 - 28.6%)
Solution:
For two assets portfolio:ERP = (WA x ERA) + (WB x ERB)
ERP = (0.286 x 14%) + (0.714 x 6%)
= 4.004% + 4.288% = 8.288%
Note: By changing the weights of assets that incorporated in the portfolio, different portfolio returns
can be achieved.

Example 2: The effect on Portfolio Return by Changing Relative Weights in A and B. Assume Mr. Tola
invested equally on the both stocks, that is, 50 % on the stock ‘A’ and 50% on the stock ‘B’. In
example1above; ERA = 14% and ERB = 6%. What is portfolio return?
Solution:ERp= (0.50 x 14%) + (0.50 x 6%)
= 7% + 3% = 10%
Further, see the below Table understand the effect of changing relative weights in A and B on portfolio
return.

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6.1.2. Portfolio Risk
The remaining computation in investment analysis is that of the risk of the portfolio. Risk is measured
by the variance (or standard deviation) of the portfolio's return, exactly as in the case of each
individual security. Typically, portfolio risk is stated in terms of standard deviation which is simply the
square root of the variance. It is at this point that the basis of modern portfolio theory emerges, which
can be stated as follows: Although the expected return of a portfolio is a weighted average of its
expected returns, portfolio risk (as measured by the variance or standard deviation) is not a weighted
average of the risk of the individual securities in the portfolio. Symbolically,

But not:

Precisely, investors can reduce the risk of a portfolio beyond what it would be if risk were, in fact,
simply a weighted average of the individual securities' risk. In order to see how this risk reduction can
be accomplished, we must analyze portfolio risk in detail.

6.1.2.1 Analyzing Portfolio Risk

Risk Reduction: To begin our analysis of how a portfolio of assets can reduce risk, assume that all risk
sources in a portfolio of securities are independent. As we add securities to this portfolio, the exposure
to any particular source of risk becomes small. According to the Law of Large Numbers, the larger the
sample size, the more likely it is that the sample mean will be close to the population expected value.
Risk reduction in the case of independent risk sources can be thought of as the insurance principle,

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named for the idea that an insurance company reduces its risk by writing many policies against many
independent sources of risk.Here, we are assuming here that rates of return on individual securities
are statistically independent such that any one security's rate of return is unaffected by another's rate
of: return.

Diversification: Diversification is the key to the management of portfolio risk, because it allows
investors; significantly to lower portfolio risk without adversely affecting return. The insurance
principle illustrates the concept of attempting to diversify the risk involved in a portfolio of assets (or
liabilities).

Random Diversification:Random or naive diversification refers to the act of randomly diversifying

without regard to relevant investment characteristics such as expected return and industry
classification. An investor simply selects a relatively large number of securities randomly. For
simplicity, we assume equal dollar amounts are invested in each stock.

Portfolio risk is not simply a weighted average of the individual security risks. Rather, as Markowitz
first showed, we must account for the interrelationships among, security returns in order to calculate
portfolio risk, and in order to reduce portfolio risk to its minimum level for any given level of return.
The reason we need to consider these, interrelationships, or co movement, among securities return.

In order to remove the inequality sign from above Equation and to develop a formula that will
calculate the risk of a portfolio as measured by the variance or standard deviation, we must account
for the following three factors. This means that; the riskiness of a portfolio that is constructed from
different risky assets is a function of three different factors:
 the riskiness of the individual assets that make up the portfolio
 the relative weights of the assets in the portfolio
 the degree of co-movement (correlation coefficient) of returns of the assets making up the
portfolio

Thus, in order to calculate portfolio variance or standard deviation; we need the actual co-
movement/covariance between securities in a portfolio. Covariance is an absolute measure of the co-
movements between securities returns used in the calculation of portfolio risk.

I. Covariance

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The covariance is an absolute measure of association between the returns for a pair of securities.
Covariance is the expected value of the product of deviations of returns from the mean/average. The
formula for calculating covariance on an expected basis is:
n
COV AB =∑ Prob i (r A , i −ER A , i )(r B , i −ERB , i )
i=1
Where;
COVAB (or σAB) = the covariance between securities A and B
rA,i = possible returns of security A
ERA,i = the expected value of the return on security A
rB,i = the possible returns of security B
ERB,i = the expected value of the return on security B
Probi = the probability of scenario i

The covariance primarily provides information about whether the association between two securities
is positive, negative, or zero. That is, value of covariance can be:

1) Positive, indicating that the returns on the two securities tend to move in the same direction at the
same time; when one increases (decreases), the other tends to do the same. When the covariance is
positive, the correlation coefficient will also be positive.
2) Negative, indicating that the returns on the two securities tend to move inversely; when one
increases (decreases), the other tends to decrease (increase), When the covariance is negative, the
correlation coefficient will also be negative.
3) Zero, indicating that the returns on two securities are independent and have no tendency to move
in the same or opposite directions together.
In general, the covariance value not tell us to which extent the returns of these two assets move
together, but it is useful to know the degree to which the returns of two assets move together; i.e.
correlation coefficient.

II. Correlation Coefficient

Even though the covariance is a supreme measure, it cannot be compared with one another. Thus, to
obtain the relative measure, the correlation coefficient is useful. Correlation coefficient is the measure
of to which extent the returns of any two securities are related. In other word, correlation coefficient
is the measure of the relative co-movements between returns of two securities. However, it indicates
only degree of relationship, not causation (i.e. it not indicates the cause & effect relationship). It is

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represented by ρij (pronounced "rho"). A formula to measure the correlation coefficient given the
covariance and standard deviation of the two assets, is:
COV AB
ρ AB =
σ A ∗σ B
Where: COVAB is the covariance between securities A and B
σA is standard deviation of security A
σB is standard deviation of security B

It is value of relative measure of association/relationship is ranges in between +1.0 and -1.0. Its value
may be:

(i) Perfect positive correlation (correlation coefficient = +1) occurs when the returns from two
securities move up and down together in proportion. If these securities were combined in a
portfolio, the ‘offsetting’ effect would not occur.
(ii) Perfect negative correlation (correlation coefficient = -1) takes place when one security moves up
and the other one down in exact proportion. Combining two securities that have perfect negative
correlationin a portfolio would increase the diversification effect.
(iii)Uncorrelated (correlation coefficient = 0) occurs when returns from two securities move
independently of each other. That is, if one goes up, the other may go up or down or may not
move at all. As a result, the combination of these two securities in a portfolio may or may not
create a diversification effect. However, it is still better to be in this position than in a perfect
positive correlation situation.

Importance of Correlation
 Correlation is important because it affects the degree to which diversification can be achieved
using various assets.
 Theoretically, if two assets returns are perfectly negatively correlated, it is possible to build a
riskless portfolio with a return that is greater than the risk-free rate.

III. Relating the Correlation Coefficient and Covariance

The covariance and the correlation coefficient can be related in the following manner:
COV AB
ρ AB =
σ A ∗σ B

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This equation shows that the correlation coefficient is simply the covariance standardized by dividing
by the product of the two standard deviations of returns. Given this definition of the correlation
coefficient, the covariance can be written as;
σAB = ρAB *σA*σB
In general, by knowing the correlation coefficient, we can calculate the covariance because the
standard deviations of the assets’ rates of return will already be available. Knowing the covariance, we
can easily calculate the correlation coefficient. To this end, knowing either covariance or correlation
coefficient of the pairs of assets in the portfolio, we can easily calculate the risk of the portfolio.

6.1.2.2. Calculating Portfolio Risk

Risk on a portfolio of securities includes correlations or co-movements of the individual security
returns in addition to the weighted impact of individual security risks. Let us first consider the simplest
possible case, two securities, in order to see what is happening in the portfolio risk equation. The
standard deviation of a two-asset portfolio (say; Stock A and B) measured by using either of the
following two formulas:

(i) Standard deviation of a two-assets portfolio using correlation coefficient:

σ p =√(w A )2 (σ A )2 +( w B )2 (σ B )2 +2(w A )(w B )( ρ A , B )(σ A )(σ B )

Factor that takes into account the degree of co-

movement of returns. It can have a negative value
if correlation is negative.
(ii) Standard deviation of a two-asset portfolio using covariance:

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When the number of assets the portfolio increases a formula to calculate its riskiness is different from
the above two formulas.

For the three-asset portfolio, a formula of standard deviation using correlation coefficient is:

σ p =√ σ 2A w 2A +σ 2B w2B +σ 2C w2C +2w A w B ρ A , B σ A σ B+2w B wC ρ B ,C σ B σ C +2w A w C ρ A ,C σ A σ C

Standard deviation of a three-asset portfoliousing covariance is calculated as follows:

σ p =√ σ 2A w 2A +σ 2B w2B +σ 2C w2C +2 w A w B Cov A ,B +2w B wC Cov B , C +2w A wC Cov A ,C

Example: Assume that stock X has a standard deviation of return of 10%. Stock Y has a standard
deviation of return of 20%. Again assume that you invest 60% of the funds in stock X and 40% in stock
Y. If correlation coefficient between stocks is 0.5, what is the standard deviation of this portfolio?

Given: σX = 10%, WX = 60%, PXY= 0.5

σY= 20%, WY = 40%, σP=?
Solution: From the given, it is clear to a formula of s tandard deviation of a two-asset portfolio using
correlation coefficient.
σ p =√(w A )2 (σ A )2 +( w B )2 (σ B )2 +2(w A )(w B )( ρ A , B )(σ A )(σ B )
σ p =√(0.6)2 (0.1)2 +(0.4)2 (0.2)2 +2(0.6)(0.4)(0.5)(0.1)(0.2)
= 0.122 or 12.2%

6.1.3. Potential diversification

The potential of an asset to diversify a portfolio is dependent upon the degree of co-movement of
returns of the asset with those other assets that make up the portfolio. In a simple, two-asset case, if the
returns of the two assets are perfectly negatively correlated it is possible (depending on the relative
weighting) to eliminate all portfolio risk. This is demonstrated by the following example:

Case (a): Correlation coefficient of -1 This is a perfect negative

correlation. So, the greatest
Correlatio diversification potential
Standard n
Expected Deviatio Coefficien
Asset Return n t
A 5.0% 15.0% -1

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 B 14.0% 40.0%

Portfolio Portfolio
Components Characteristics
Weight Weight Expected Standard
of A of B Return Deviation
100.00% 0.00% 5.00% 15.0%
90.00% 10.00% 5.90% 9.5%
Risk of the portfolio is
80.00% 20.00% 6.80% 4.0% almost eliminated at
70% invested in asset A
70.00% 30.00% 7.70% 1.5%
60.00% 40.00% 8.60% 7.0%
50.00% 50.00% 9.50% 12.5%
40.00% 60.00% 10.40% 18.0%
30.00% 70.00% 11.30% 23.5%
20.00% 80.00% 12.20% 29.0%
10.00% 90.00% 13.10% 34.5%
0.00% 100.00% 14.00% 40.0%

Case (b): Correlation coefficient of +1

It is indicates a perfect
Standard Correlatio positive correlation.

Expected Deviatio n
Asset Return n Coefficient
A 5.0% 15.0% 1
B 14.0% 40.0%

Portfolio Components Portfolio Characteristics

Weight of Expected Standard

A Weight of B Return Deviation
100.00% 0.00% 5.00% 15.0%
90.00% 10.00% 5.90% 17.5%
80.00% 20.00% 6.80% 20.0%

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 70.00% 30.00% 7.70% 22.5%
Here, there is no reduction
60.00% 40.00% 8.60% 25.0% of portfolio risk. Thus,
diversification is not
50.00% 50.00% 9.50% 27.5% possible.
40.00% 60.00% 10.40% 30.0%
30.00% 70.00% 11.30% 32.5%
20.00% 80.00% 12.20% 35.0%
10.00% 90.00% 13.10% 37.5%
0.00% 100.00% 14.00% 40.0%
6.2. EFFICIENT FRONTIER
The efficient frontier describes the relationship between the expected return of a portfolio and the risk
(volatility) of the portfolio. It can be drawn as a curve on a graph of risk against expected return of a
portfolio. The efficient frontier shows the best return that can be expected for a given level of ris k or
the lowest level of risk needed to achieve a given expected rate of return. It is a line created from the
risk-reward graph, comprised of optimal portfolios.

The efficient frontier is a key concept of modern portfolio theory. Things get rather more interesting in
post-modern portfolio theory which has an infinite number of efficient frontiers. The efficient frontier
for each investor depends on their risk acceptance and preferences. The efficient frontier is usually
used to describe the curve that is drawn in the absence of a risk free asset. When a risk free asset
available the curve becomes a straight line, i.e. securities market line.

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The market portfolio lies in the efficient frontier, at the point at which it touches the securities market
line. The efficient frontier is extremely important to the theory of portfolio construction and valuation.
Every possible asset combination can be plotted in risk-return space, and the collection of all such
possible portfolios defines a region in this space. The line along the upper edge of this region is known
as the efficient frontier.

Combinations along this line represent portfolio of risky assets only, it not include the risk-free asset
which has a lowest level of risk for a given level of return. Conversely, for a given level of risk, the
portfolio lying on the efficient frontier represents the combination offering the best possible return.
Mathematically, the efficient frontier is the intersection of the set of portfolios with minimum variance
and the set of portfolios with maximum return.

Markowitz's Efficient Portfolios

Markowitz's approach to portfolio selection is that an investor should evaluate portfolios on the basis
of their expected returns and risk as measured by the standard deviation. He was the first to derive die
concept of an efficient portfolio, which is defined as one that has the smallest portfolio risk for a given
level of expected return or the largest expected return for a given level of risk. Investors can identify
efficient portfolios by specifying an expected portfolio return and minimizing the portfolio-risk at this
level of return. Alternatively, they can specify a portfolio risk level they are willing to assume and
maximize the expected return on the portfolio for this level of risk. Rational investors will seek
efficient portfolios, because these portfolios are optimized on the two dimensions of most importance
to investors, expected return and risk.

To begin our analysis, we must first determine the risk-return opportunities available to an investor
from a given set of securities. A large number of possible portfolios exist when we realize that varying-
percentages of an investor's wealth can be invested in each of the assets under consideration investors
should be interested in only that subset of the available portfolios known as the efficient set.

The assets generate the attainable set of portfolios, or the opportunity set. The attainable set is the
entire set of all portfolios that could be found from a group of n securities. However, risk-averse
investors should be interested only in those portfolios with the lowest possible risk for any given level
of return. All other portfolios in the attainable set are dominated.

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Using the inputs described earlier; expected returns, variances, and co variances; we can calculate the
portfolio with the smallest variance, or risk, for a given level of expected return based on these inputs.
Given the minimum-portfolios, we can plot the minimum variance frontier. Point V represents, the
market minimum-variance portfolio, because no other minimum-variance portfolio has a smaller risk.
The bottom segment of tile minimum variance frontier (VA) is dominated by portfolios on the upper
segment (VB). For example, since portfolio B has a larger return than portfolio A for the same level of
risk, investors would not want to own portfolio A.

The segment of the minimum-variance frontier above the market minimum variance portfolio, VB,
offers the best risk-return combinations available to investors from this particular set of inputs, this
segment is referred to as the efficient set of portfolios. This efficient set is determined by the principle
of dominance; portfolio B dominates portfolio A if it has the same level of risk but a larger expected
return or the same expected return but a lower risk.

The solution to the Markowitz model revolves around the portfolio weights, or percentages of
investable funds to be invested in each security. Because the expected returns, standard deviations, and
correlation coefficients for the securities being considered are inputs in, the Markowitz analysis, the
portfolio weights are the only variable that can be manipulated to solve the portfolio problem of
determining efficient portfolios.

To select an optimal portfolio of financial assets using the Markowitz Principles/analysis; investors
should;
(i) Identify optimal risk-return combinations available from the set of risky assets being considered by
using the Markowitz efficient frontier analysis. This step; uses the inputs from, the expected
returns, variances, and covariances for a set of securities.

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(ii) Choose the final portfolio from among those in the efficient set based on an investor's preferences.

Even if portfolios are selected arbitrarily, some diversification benefits are gained. This results in a
reduction of portfolio risk. However, to take; the full information set into account, we use portfolio
theory as developed by Markowitz, Portfolio theory is nonnative, meaning that it tells investors; how
they should act to diversify optimally. It is based on a small set of assumptions, including;
(i) A single investment period; for example, one year.
(ii) Liquidity of positions; for example, there are no transaction costs.
(iii)Investor preferences based only on a portfolio's expected return and risk; as measured by
variance or standard deviation.

6.3. SINGLE INDEX MODEL

Single index model is a model which assumes that the co-movement between stocks is due the single
common influence by market performance. Hence, the measure of this index (i.e. single common
factor), can be found by relating the stock return to the return on a stock market index. Mathematical
formula for single index model is:
E(ri) = αi + βirm + ei
where:
E(ri) = return on stock i
αi = component of stock i’s return that is independent of the market’s performance; αi= E(ri) - βirm
rm = the rate of return on the market index
βi = measures the expected change in ri given a change in rm, βi = Covi,m/s2m
ei =unexpected component (residual)

These equations show that the stock return is influenced by the market (beta), has a firm specific
expected value (alpha) and firm-specific unexpected component (residual). According to single index
model; expected return, variance and covariance can be estimated as follows when they are used to
represent the joint movement of stocks:
Mean return of stock, E(r)i= αi + βirm
Variance of a stock’s return, σ2i = β2iσ2m + σ2ei
Covariance of returns between stocks i& j, σij = βiβjσ2m
where: σ2m = market variance, and
σ2ei = unique risk factor (firm specific risk)

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6.4. CAPITAL MARKET THEORY
Following the development of portfolio theory by Markowitz, two major theories have been derived.
These are: capital market theory and arbitrage pricing theory. Arbitrage Pricing Theory (APT) specifies
several risk factors or its multifactor asset valuation model. Capital market theory extends Markowitz’s
portfolio theory, by assuming the existence of a risk-free asset additionally and it develops a model for
pricing all risky assets; i.e. the CAPM.

Capital market theory and capital asset pricing model (CAPM) were developed almost concurrently.
CAPM considered the underlying assumptions of the Markowitz portfolio theory, however,
additionally it assuming the existence of a risk-free asset, i.e. an asset with zero variance.

6.4.1. Capital Assets Pricing Model (CAPM)

What is CAPM?The CAPM was introduced by Jack Treynor, John Lintner, William Sharpe and Jan
Mossin in the early 1960’s. CAPM is models that establish the linear relationship between un-
diversifiable risk (systematic risk) and expected return. According to CAPM, the investor needs to be
compensated in two ways, for time value of money (risk free rate) and for taking systematic risk. A
security’s expected return is risk free rate plus a premium based on the systematic risk of security. The
CAPM assumes any asset’s systematic risk is captured by one risk factor, i.e. the market risk factor.
Adding one new stock to a well-diversified portfolio affects the risk of the portfolio depending upon
the asset’s degree of market risk, as measured by its Beta. Investing in risky assets such as the market
portfolio should carry a premium compared to the risk-free rate. Otherwise, investors will not take the
risk. The risk premium on the market portfolio, measure as the difference between the market return
and the risk-free rate is called the market risk premium. If investors are mainly concerned with the
risk of their portfolio rather than the risk of the individual securities in the portfolio, how should the
risk of an individual stock be measured?

Assumptions of CAPM
(i) Investors are risk averse individuals and they maximise their expected utility of their end of period
wealth.
(ii) Investors have the same one period of time horizon.
(iii)Investors are price takers (no single investor can affect the price of a stock) and have homogenous
expectation about asset returns that have a joint normal distribution.

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(iv) Investors can borrow or lend money at the risk-free rate of return.
(v)The quantities of assets are fixed. All assets are marketable and perfectly divisible.
(vi) Asset markets are frictionless and information is costless and simultaneously available to all
investors.
(vii) There are no market imperfections such as no taxes, no transaction costs or no restrictions on
short selling.

Thus, although these assumptions do not realistic in the real world, they are used to make the model
simpler for us to use for financial decision making. Most of these assumptions can be relaxed.

 The CAPM requires that in equilibrium the market portfolio must be an efficient portfolio.

 As long as all assets are marketable, divisible and investors have homogenous expectations, all
individuals will perceive the same efficient set and all assets will be hold in equilibrium.

 If every individual holds a percentage of their wealth in efficient portfolios, and all assets are
held, then the market portfolio must be also efficient because the market is simply the sum of
all individual holdings and all individual holdings are efficient.

 Without the efficiency of the market portfolio the capital asset pricing model is un-testable.

In a competitive market, the expected risk premium varies in direct proportion to beta.

 i.e., Expected risk premium = beta ´ market risk premium.

The risk of each stock is measured by its beta and the risk premium varies in direct proportion to beta.
All stocks will lie along the SML and the expected return on a stock can be calculated by adding the
risk premium to the risk-free rate. i.e., Expected return= risk premium + risk-free rate

For an individual risky asset, the relevant risk measure is the covariance of its returns with the return
on the market portfolio. An alternative measure called beta is also used. The beta coefficient of an asset
i, βi, used to measure covariance, is defined as:

where,σi,M= is the covariance of the return on the asset i and the return on the market portfolio
σ2M= is the variance of return on the market portfolio.

Thus, the equation used for CAPM is as follows:

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 Ki = Krf+ βi(Km - Krf)

Where: Ki = the required return for the individual security i.

Krf= the risk-free rate of return
βi= the beta of the individual security
Km = the expected return on the market portfolio
(Km - Krf) is called the market risk premium, i.e. expected return on the market portfolio minus
risk-free rate of return.
This equation can be used to find any of the variables listed above, given the rest of the variables are
known.

Example 1: Find the required return on a stock given that the risk-free rate is 8%, the expected return
on the market portfolio is 12%, and the beta of the stock is 2.
Ki = Krf+ βi(Km - Krf)
Ki = 8%+ 2(12% - 8%)
Ki = 16%
Note that you can then compare the required rate of return to the expected rate of return. You would
only invest in stocks where the expected rate of return exceeded the required rate of return.

Example2: Find the beta on a stock given that its required return is 12%, the risk-free rate is 4%, and
the expected return on the market portfolio is 10%.
12%= 4%+ βi(10% - 4%)
βi= (12% - 4%)
(10% - 4%)
βi= 1.33

Note that beta measures the stock’s volatility (or risk) relative to the market.
 The least risky investment is T-bills, since the return on them is fixed, it is unaffected by what
happens to the market. (beta = 0),
 The riskier investment is market portfolio of common stocks (average beta = 1)
 Risk premium (excess return) is expected returns minus risk free return.
 The relationship between systematic risk and expected return in financial markets is usually
called the security market line (SML).

Security Market Line (SML)

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The relationship between an individual security’s expected rate of return and its systematic risk as
measured by beta will be linear, this relationship is called as Security Market Line.

The graph depicts the SML of Securities A, B, and C:

 Beta = 1.0 implies as risky as market

 Securities A and B are more risky than the market: Beta >1.0
 Security C is less risky than the market: Beta <1.0

Now, if everyone holds the market portfolio, and if beta measures each security’s contribution to the
market portfolio risk, then it’s no surprise that the risk premium demanded by investors is
proportional to beta. This is what the CAPM says.

Critique of CAPM:
 Unrealistic assumptions: CAPM is not without controversy. It rests on some critical (and
questionable) assumptions.
 Not testable: An empirical test does not confirm CAPM.
 CAPM does not explain differences of returns for securities that differ; over time, dividend yield,
size effect.

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6.4.2. Arbitrage Pricing Theory (APT)
According to APT also, only the systematic risk is relevant in determining expected returns (similar to
CAPM). However, there may beseveral systematic (non-diversifiable) risk factors such as; economic
growth, interest rates, and inflation (different from CAPM, which assumes only one risk factor) that is
systematic or macroeconomic in general and that affect the returns of all stocks to some degree. Since
firm specific risks are easily diversified out of any well-diversified portfolio, they are not relevant in
determining the expected returns of securities (similar to CAPM).

The basic idea behind Arbitrage Pricing Theory is to calculate the returns in absence of arbitrage -
condition of artificially overpricing or under-pricing a product. In other language, arbitrage is the
process of earning profit by taking advantage of differential pricing for the same asset. Arbitrage
Pricing Theory applies to economies that are regulated by the Law of One Price. The Law of one price
states that two identical goods can’t be sold at different price, but be sold with the same price. If they
sell at different price arbitrage takes up.

APT Assumes:
 Only systematic or non-diversifiable risk matters, but there may be several of these
macroeconomic risk factors that affect the returns of well-diversified portfolios. Such common risk
factors might happen to be are; unexpected changes in economic growth, interest rates, and
inflation.
 Investors must agree on what the relevant risk factors are. There must be a linear relationship
between the risk exposure or sensitivity (its loadings on the risk factors) andexpected return of a
security.

A representation of APT model which holds ‘ n’ number of risk factors common stock, would look like
the following:
E(Ri) = ai + bi1[RP1] + bi2[RP2] + … … .. + bin[RPn]

where: ai = the expected return on an asset with zero systematic risk (i.e. RFR)
RPj = the risk premium related to the jth risk factor
bin= the pricing relationship between the risk premium and the asset; that is, how responsive
asset i is to the nth risk factor. These are called factor betas

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For example: In order to illustrate how the model works we will assume that there are two common
factors: one related to unexpected changes in the level of inflation and another related to
unanticipated changes in the real level of GDP.

If we further assume that the risk premium related to GDP sensitivity is 0.03 and a stock that is
sensitive to GDP has a bj (where j represents the GDP factor) of 1.5, this means that this factor would
cause the stock’s expected return to increase by 4.5 percent (= 1.5 × 0.03). To develop this notion
further, consider the following example of two stocks and a two factor model.

First, consider these risk factor definitions and sensitivities:

 Unanticipated changes in the rate of inflation. The risk premium related to this factor is 2
percent for every 1 percent change in the rate (RP1 = 0.02)
 Unexpected changes in the growth rate of real GDP. The average risk premium related to this
factor is 3 percent for every 1 percent change in the rate of growth (RP 2 = 0.03)
 The rate of return on a zero-systematic risk asset (i.e., zero beta) is 4 percent (RFR = 0.04)

Assume also that there are two assets (x and y) that have the following response coefficients to these
common risk factors:
 The response of asset x to changes in the inflation factor is 0.50 (bx,1 = 0.50)
 The response of asset x to changes in the GDP factor is 1.50 (bx,2 = 1.50)

These factor sensitivities can be interpreted in much the same way as beta in the CAPM; that is, the
higher the level of bij, the greater the sensitivity of asset ito changes in the jth risk factor. Thus, the
response coefficients listed indicate that if these are the major factors influencing asset returns,
therefore, its expected return should be greater. The overall expected return equation will be:

E(Ri) = ai + bi1[RP1] + bi2[RP2]

= 0.04 + bi1 (0.02) + bi2 (0.03)
Therefore, for assets x:
E(Rx) = 0.04 + (0.50)(0.02) + (1.50)(0.03)
= 0.0950 = 9.50%

Chapter 7: Portfolio Management

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Portfolio management involves a series of decisions and actions that must be made by every investor
whether an individual or institution. Portfolios must be managed whether investors follow a passive
approach or active approach to selecting and holding their financial assets. The effective and efficient
management of portfolio enable investment of funds in such combination of different securities in
which the total risk of portfolio is minimized, and rate of returns is maximized.

7.1.What is Portfolio Management?

Portfolio managementis the process of combining securities in a portfolio according to the investor’s
preferences and needs, monitoring that portfolio, and evaluating its performance.

In other word, portfolio management is the strategic decision guides the investor in a method of
selecting the best available securities that will provide the expected rate of return for a given degree of
risk and also to reduce the risk.

7.2. Objectives of Portfolio Management

The primary objective of portfolio management is to invest in securities in a way that it maximizes
one’s returns and minimizes risks in order to achieve one’s investment objective.

(i) Security of principal investment: Investment safety or minimization of risks is one of the important
objectives of portfolio management.
(ii) Consistency of return: Portfolio management also ensures to provide the stability of returns by
reinvesting the earned returns in profitable and good portfolio. Since returns of all securities do
not move exactly together, variability in one security will be offset by the reverse variability of
other securities; and ultimately the overall risk of the investor will be less affected. The earned
returns should compensate the opportunity costs of the funds invested.

A good portfolio should have multiple objectives and achieve a sound balance among:
i.
ii. Stable Return v. Capital appreciation
iii. Safety of the investment vi. Liquidity
iv. Tax Planning

In addition, the basic principles necessary for executing an investment program. These are known as
guiding principles in establishing an investment portfolio. They include:Safety of Funds, Consistency of
returns and Liquidity/Marketability

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 7.3. Portfolio Management Process
In setting out to master the concepts and tools of portfolio management, we first need a coherent
description of the portfolio management process. The portfoliomanagement processis an integrated set
of steps undertaken in a consistent manner to create and maintain an appropriate portfolio
(combination of assets) to meet clients’ stated goals.

The process of managing an investment portfolio never stops. Once the funds are initially invested
according to the plan, the real work begins in monitoring and updating the status of the portfolio and
the investor’s needs. Three elements in managing any business process are planning, execution, and
feedback.

Specification and
quantification of investor’s Monitoring investor-
Portfolio Policies
objectives, constraints and related input factors
& Strategies
preferences

Portfolio construction Attainment of

and revision investor’s
Asset allocation, portfolio objectives
optimization, security Performance
selection, evaluation
implementation, and
execution

Monitoring economic
Capital market and market input
Relevant economic, expectations factors
social,political, and sector
consideration

Exhibit 7.1: Portfolio Construction, Monitoring and Revision Process

7.3.1. The Planning Step
The planning step is described in the four leftmost boxes in Exhibit 7.1. The top two boxes represent
investor-related input factors, while the bottom two factors represent economic and market input.

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i) Identifying and Specifying the Investor’s Objectives and Constraints: The first task in investment
planning is to identify and specify the investor’s objectives and constraints. Investment objectives are
desired investment outcomes. In investments, objectives mainly pertain to return and risk. Constraints
are limitations on the investor’s ability to take full or partial advantage of particular investments. For
example, an investor may face constraints related to the concentration of holdings as a result of
government regulation, or restrictions in a governing legal document. Constraints are either internal,
such as a client’s specific liquidity needs, time horizon, and unique circumstances, or external, such as
tax issues and legal and regulatory requirements.

ii) Creating the Investment Policy Statement (IPS): Once a client has specified a set of objectives and
constraints, the manager’s next task is to formulate the investment policy statement. The IPS serves as
the governing document for all investment decision making. In addition to objectives and constraints,
the IPS may also cover a variety of other issues.

For example, the IPS generally details reporting requirements, rebalancing guidelines, frequency and
format of investment communication, manager fees, investment strategy, and the desired investment
style or styles of investment managers. Atypical IPS includes the following elements:

 A brief client description.

 The purpose of establishing policies and guidelines.
 The duties and investment responsibilities of parties involved, particularly those relating to
fiduciary duties, communication, operational efficiency, and accountability. Parties
involved include the client, any investment committee, the investment manager, and the
bank custodian.
 The statement of investment goals, objectives, and constraints.
 The schedule for review of investment performance as well as the IPS itself.
 Performance measures and benchmarks to be used in performance evaluation.
 Any considerations to be taken into account in developing the strategic asset allocation.
 Investment strategies and investment style(s).
 Guidelines for rebalancing the portfolio based on feedback.
The IPS forms the basis for the strategic asset allocation, which reflects the interaction of objectives and
constraints with the investor’s long-run capital market expectations. When experienced professionals

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include the policy allocation as part of the IPS, they are implicitly forming capital market expectations
and also examining the interaction of objectives and constraints with long-run capital market
expectations. In practice, one may see IPSs that include strategic asset allocations, but we will maintain
a distinction between the two types.

The planning process involves the concrete elaboration of an investment strategy; that is, the
manager’s approach to investment analysis and security selection. A clearly formulated investment
strategy organizes and clarifies the basis for investment decisions. It also guides those decisions toward
achieving investment objectives. In the broadest sense, investment strategies are passive, active, or
semi-active.

In a passive investment approach, portfolio composition does not react to changes in capital market
expectations (passive means ‘‘not reacting’’). For example, a portfolio indexed to the Morgan Stanley
Capital International (MSCI)-Europe Index, an index representing European equity markets, might
add or drop a holding in response to a change in the index composition but not in response to changes
in capital market expectations concerning the security’s investment value. Indexing, a common passive
approach to investing, refers to holding a portfolio of securities designed to replicate the returns on a
specified index of securities. A second type of passive investing is a strict buy-and-hold strategy, such
as a fixed, but non-indexed, portfolio of bonds to be held to maturity.

In contrast, with an active investment approach, a portfolio manager will respond to changing capital
market expectations. Active management of a portfolio means that its holdings differ from the
portfolio’s benchmark or comparison portfolio in an attempt to produce positive excess risk-adjusted
returns, also known as positive alpha. Securities held in different-from-benchmark weights reflect
expectations of the portfolio manager that differ from consensus expectations. If the portfolio
manager’s differential expectations are also on average correct, active portfolio management may add
value.

A third category, the semi-active, risk-controlled active or enhanced index approach, seeks positive
alpha while keeping tight control over risk relative to the portfolio’sbenchmark. As an example, an
index-tilt strategy seeks to track closely the risk of a securitiesindex while adding a targeted amount of
incremental value by tilting portfolio weightingsin some direction that the manager expects to be
profitable.

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Active investment approaches encompass a very wide range of disciplines. To organize this diversity,
investment analysts appeal to the concept of investment style. We can define an investment style (such
as an emphasis on growth stocks or value stocks) as a natural grouping of investment disciplines that
has some predictive power in explaining the future dispersion in returns across portfolios. We will
take up the discussion of investment strategies and styles in greater detail in subsequent chapters.

iii) Forming Capital Market Expectations: The manager’s third task in the planning process is to form
capital market expectations. Long-run forecasts of risk and return characteristics for various asset
classes form the basis for choosing portfolios that maximize expected return for given levels of risk, or
minimize risk for given levels of expected return.

iv) Creating the Strategic Asset Allocation: The fourth and final task in the planning process is
determining the strategic asset allocation. Here, the manager combines the IPS and capital market
expectations to determine target asset class weights; maximum and minimum permissible asset class
weights are often also specified as a risk-control mechanism. The investor may seek both single-period
and multi-period perspectives in the return and risk characteristics of asset allocations under
consideration. A single-period perspective has the advantage of simplicity. A multi-period perspective
can address the liquidity and tax considerations that arise from rebalancing portfolios over time, as
well as serial correlation (long- and short-term dependencies) in returns, but is more costly to
implement.

The execution and feedback steps in the portfolio management process are as important as the
planning step and will receive more attention in subsequent chapters. For now, we merely outline how
these steps fit in the portfolio management process.

7.3.2. The Execution Step

The execution step is represented by the ‘‘portfolio construction and revision’’. In the execution step,
the manager integrates investment strategies with capital market expectations to select the specific
assets for the portfolio (the portfolio selection/compositiondecision). Portfolio managers initiate
portfolio decisions based on analysts’ inputs, and trading desks then implement these decisions
(portfolio implementation decision). Subsequently, the portfolio is revised as investor circumstances or
capital market expectations change; thus, the execution step interacts constantly with the feedback
step.

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In making the portfolio selection/composition decision, portfolio managers may use the techniques of
portfolio optimization. Portfolio optimization is quantitative tools for combining assets efficiently to
achieve a set of return and risk objectives -plays a key role in the integration of strategies with
expectations and appears in Exhibit 7.1 in the portfolio construction and revision box.

At times, a portfolio’s actual asset allocation may purposefully and temporarily differ from the
strategic asset allocation. For example, the asset allocation might change to reflect an investor’s current
circumstances that are different from normal. The temporary allocation may remain in place until
circumstances return to those described in the IPS and reflected in the strategic asset allocation. If the
changed circumstances become permanent, the manager must update the investor’s IPS, and the
temporary asset allocation plan will effectively become the new strategic asset allocation. A strategy
known as tactical asset allocation also results in differences from the strategic asset allocation. Tactical
asset allocation responds to changes in short-term capital market expectations rather than to investor
circumstances.

The portfolio implementation decision is as important as the portfolio selection/ composition decision.
Poorly managed executions result in transaction costs that reduce performance. Transaction costs
include all costs of trading, including explicit transaction costs, implicit transaction costs, and missed
trade opportunity costs. Explicit transaction costs include commissions paid to brokers, fees paid to
exchanges, and taxes. Implicit transactioncosts include bid-ask spreads, the market price impacts of
large trades, missed trade opportunity costs arising from price changes that prevent trades from being
filled, and delay costs arising from the inability to complete desired trades immediately due to order
size or market liquidity.

In sum, in the execution step, plans are turned into reality with all the attendant real-world
challenges.

7.3.3. The Feedback Step

In any business endeavor, feedback and control are essential elements in reaching a goal. In portfolio
management, this step has two components: monitoring and rebalancing, and performance evaluation.

i) Monitoring and Rebalancing: Monitoring and rebalancinginvolve the use of feedback to manage
ongoing exposures to available investment opportunities so that the client’s current objectives and

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 constraints continue to be satisfied. Two types of factors are monitored: investor-related factors
such as the investor’s circumstances, and economic and market input factors.

One impetus for portfolio revision is a change in investment objectives or constraints because of
changes in investor circumstances. Portfolio managers need a process in place to stay informed of
changes in clients’ circumstances. The termination of a pension plan or death of a spouse may trigger
an abrupt change in a client’s time horizon and tax concerns, and the IPS should list the occurrence of
such changes as a basis for appropriate portfolio revision.

More predictably, changes in economic and market input factors give rise to the regular need for
portfolio revision. Again, portfolio managers need to systematically review the risk attributes of assets
as well as economic and capital market factors. A change in expectations may trigger portfolio
revision. When asset price changes occur, however, revisions can be required even without changes in
expectations. The actual timing and magnitude of rebalancing may be triggered by review periods or
by specific rules governing the management of the portfolio and deviation from the tolerances or
ranges specified in the strategic asset allocation, or the timing and magnitude may be at the discretion
of the manager.

For example, suppose the policy allocation calls for an initial portfolio with a 70 percent weighting to
stocks and a 30 percent weighting to bonds. Suppose the value of the stock holdings then grows by 40
percent, while the value of the bond holdings grows by 10 percent. The new weighting is roughly 75
percent in stocks and 25 percent in bonds. To bring the portfolio back into compliance with
investment policy, it must be rebalanced back to the long-term policy weights. In any event, the
rebalancing decision is a crucial one that must take into account many factors, such as transaction
costs and taxes (for taxable investors). Disciplined rebalancing will have a major impact on the
attainment of investment objectives. Rebalancing takes us back to the issues of execution, as is
appropriate in a feedback process.

ii) Performance Evaluation: Investment performance must periodically be evaluated by the investor to
assess progress toward the achievement of investment objectives as well as to assess portfolio
management skill.

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7.4. Portfolio Management Policies
Policies followed in management of portfolio differ from investor to investor. The following are the
basic policies which are most commonly followed in the portfolio management.
1) Aggressive Policy: is a policy that assumes the market is strong and rising. Common stock is the
best alternative investment for the portfolio in rising market.
2) Defensive Policy: According to this policy, the securities which resist a decline in price are chosen
for investment. Since common shares are more risky (because it’s residual claim), bonds and
preferred shares are defensive type securities.
3) Aggressive-Defensive Policy: This type of policy safeguards the investor against any possible rise or
fall in the stock market. If the market is in rising trend, equity stock would bring a large income. If
the market is affected by recession, preferred stocks, bonds, debentures will protect the investor.
4) Income vs. Growth Policy: The income policy focuses on maximization of current income, but does
not consider capital gains. This policy suggests bonds and debentures. The growth policy gives
priority to capital appreciation of the portfolio. It is followed by the investors who favor stocks,
promising substantial capital appreciation.
In general, the income Vs growth policy emphasizes that both income and growth factors should be
given due importance while constructing investment portfolio which will assure the investor current
income as well as increase in its capital value.

7.5.Portfolio Evaluation: Risk-Adjusted Portfolio Performance Measures

Portfolio evaluation is the stage where we examine to what extent the objective has been achieved.
Through portfolio evaluation the investor tries to find out how well the portfolio has performed. The
portfolio evaluation is really a study of the impact/result of previous decisions. Without portfolio
evaluation, portfolio management would be incomplete.

Investment analysts and portfolio managers continuously monitor and evaluate the outcome of their
performance. The basic features of good portfolio managers are their ability to perceive the market
trends correctly and make correct expectations & estimates regarding risk, return, ability to make
proper diversification, to reduce the company related risk. In addition, portfolio performance also
depends on the timing of investments, superior investment analysis and security selection. For
evaluating the performance of a portfolio it is necessary to consider both risk and return.

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Measuring the risk associated with a portfolio is one important aspect of measuring portfolio
performance. Portfolio returns must be adjusted for risk before they can be compared meaningfully.
The easiest way to adjust returns for portfolio risk is to compare rates of return amongst portfolios
with similar risk profiles. This process may be misleading, however, for some managers may
concentrate on particular subgroups, so that the portfolio profiles are not actually that comparable.
More accurate measures of portfolio returns have come into vogue to calculate risk-adjusted returns
using mean-variance criteria and measuring both risk and return. Risk-adjusted returns are not
necessarily perfect measurements, as they do not take into account transaction costs. They are,
however, important tools for providing information about portfolios. Three of the most popular risk-
adjusted measures will now be examined. These are: Sharpe measure, Treynor measure and the Jensen
measure. They differ from one another according to the risk measure used.

1) Sharpe Measure: The performance measure developed by William Sharpe is referred to as the
reward-to-variability ratio or Sharpe ratio. It is the ratio of reward or risk premium to the
variability of return which measured by the standard deviation of return. The formula for
calculating Sharpe ratio may be stated as:
Sharpe ratio (SR) = (rp - rf ) / sp

Where, rp = Realized return on the Portfolio

rf = Risk free rate of return
sp = Standard deviation of portfolio return
The higher the value of this measure the better value the portfolio represents, since as p gets smaller
the total risk of the portfolio gets smaller. If the Sharpe ratio is negative the portfolio’s performance is
less than the risk-free rate and the negative figure itself cannot be compared to other negative figures.

2) Treynor Measure: The performance measure developed by Jack Treynoris referred to as Treynor
ratio or reward to variability ratio like Sharpe. However, Treynor, distinguished between total risk
and systematic risk, implicitly assuming that portfolios are well diversified; that is, he ignored any
diversifiable risk. It is the ratio of the reward or risk premium to the volatility of return as
measured by the portfolio Beta. The formula for calculating Treynor ratio is stated as follows:

Treynor ratio (TR) = (rp - rf ) / bp

Where, rp = Realized return on the Portfolio

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 rf = Risk free rate of return
bp = Portfolio beta
The higher the value of the Treynor measure the better the value represented by the portfolio, since a
higher beta represents higher systematic risk. The Treynor measure may be preferred by investors who
are running highly diversified portfolios, as the measure does not consider unsystematic risk. A
portfolio holding a large number of investments should see the unsystematic risk diversified away. The
Sharpe measure, which considers total risk, may be preferred by investors with less diversified
portfolios.

3) Jensen Measure: This performance measure has been developed by Michael Jensen and is referred
to as the Jensen ratio. This ratio attempts to measure the difference between the actual return
earned on a portfolio and the expected return from the portfolio given its level of risk. Jensen's
measure of performance is based on the capital asset pricing model (CAPM). The expected return
for any security (i) or, in this case, portfolio (p) is given as; E(rp) = rf+ bp(rm - rf )

Jensen ratio (JR) = rp - E(rp)

Where: E(rp) = Expected return of portfolio

rp = Realized return on the Portfolio
rf = Risk free rate of return
bp = Portfolio beta
rm = Return on market index
To summarize:
 The Sharpe ratio looks at total risk
 The Treynor ratio takes into account systematic risk
 The Jensen measure looks at the performance of the portfolio over and above that of a
benchmark.

If an investor has limited holdings, then standard deviation may provide a more accurate measure of
risk. Likewise, if an investor holds a wide variety of holdings outside of one particular mutual fund,
then beta may be a more accurate measure of risk.

For example, two fund managers are employed to manage two portfolios with identical objectives.
Details of their portfolios are as follow:

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 Fund Return Beta (p) Total risk (p)
A 10% 1.03 10%
B 14% 1.25 20%

Using the Sharpe measure, where:

Sharpe measure = Rp – Rf (assume Rf = 4.5%)
p
Fund A = (10 – 4.5)/10 = 0.55
Fund B = (14 – 4.5)/20 = 0.48

It can be concluded that, on a risk-adjusted basis considering total risk, fund manager A has
outperformed fund manager B.

Using the Treynor measure, where:

Treynor measure =(Rp – Rf)/p
Fund A = (10 – 4.5)/1.03 = 5.34%
Fund B = (14 – 4.5)/1.25 = 7.6%

It can be concluded that, on a risk-adjusted basis taking into account systematic risk, fund manager B
has outperformed fund manager A.

Using the Jensen measure, where:

Jensen measure == Rp – Rb
Rb = Rf + b (Rm – Rf ) (assume Rm = 8%)
Ra = 4.5 + 1.03(8 – 4.5) = 8.1%
Rb = 4.5 + 1.25(8 – 4.5) = 8.9%
a = Ra = 10.0 – 8.1 = 1.9%
b = Rb = 14.0 – 8.9 = 5.1%

It can be concluded that on a risk-adjusted basis (systematic risk), fund manager B has performed
better than fund manager A.

One more point to note is that returns will be affected by tax rates, inflation over time, and foreign
exchange rates when applicable

7.6. Portfolio Revision

In portfolio management, the maximum emphasis is placed on portfolio analysis and selection which
leads to the construction of the optimal portfolio. But, the financial markets are continually changing.

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In this dynamic environment, a portfolio that was optimal when constructed may not continue to be
optimal with the passage of time. The portfolio management process needs frequent changes in the
composition of stocks and bonds. If the policy of the investor shifts from earnings to capital
appreciation, the stocks should be revised accordingly. Likewise, if the security does not fulfill the
investors expectation regarding return and growth, it is better to get rid of it. If another stock offers a
competitive edge over the present stock, investment should be shifted to the other stock. Many
investors find themselves inadequate in their ability to trade and earn profit.

7.6.1. Need for Revision

The primary factor necessitating portfolio revision is changes in the financial markets since the
creation of the portfolio. The need for portfolio revision may arise because some investor related
factors also. These factors may be listed as:
 Ability of additional funds for investment
 Change in risk tolerance
 Change in the investment goals
 Need to liquidate a part of the portfolio to provide funds for some alternative use.
The portfolio needs to be revised to accommodate the changes in the investor’s position. Thus, the need
for portfolio revision may arise from changes in the financial market or changes in the investor’s
position, namely his status and preferences.

7.6.2. Portfolio Revision Strategies

Two different strategies may be adopted for portfolio revision, namely
a) Active Revision Strategy
b) Passive Revision Strategy
The choice of the strategy would depend on the investor’s objectives, skill, resources and time.

Active Revision Strategy:Active revision strategy involves frequent and sometimes substantial
adjustments to the portfolio. The effectiveness of an actively-managed investment portfolio obviously
depends on the skill of the manager and research staff but also on how the term active is defined.
Investors who undertake active revision strategy believe that security markets are not continuously
efficient. They believe that securities can be mispriced at times giving an opportunity for earning
excess returns through trading in them. Active portfolio revision is essentially carrying out portfolio

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analysis and portfolio selection all over again. It is based on an analysis of the fundamental factors
affecting the economy, industry and company as also the technical factors like demand and supply.

Consequently, the time, skill and resources required for implementing active revision strategy will be
much higher. The frequency of trading is likely to be much higher under active revision strategy
resulting in higher transaction costs.

Passive Revision Strategy:Passive portfolio strategy, in contrast, involves only minor and infrequent
adjustment to the portfolio over time. The practitioner of passive revision strategy believes in market
efficiency and homogeneity of expectation among investors. They find little incentive for actively
trading and revising portfolios periodically.

Under passive revision strategy, adjustment to the portfolio is carried out according to certain
predetermined rules and procedures designated as formula plans. These formula plans help the
investor to adjust his portfolio according to changes in the securities market.

7.7. Formula Plans

Formula plans represent an attempt to exploit the price fluctuations in the market and make them a
source of profit to the investor. They make the decisions on timings of buying and selling securities
automatic and eliminate the emotions surroundings the timing decisions. Formula plans consist of
predetermined rules regarding when to buy or sell and how much to buy or sell. These predetermined
rules call for specified actions when there are changes in the securities market.

The use of formula plans demands that the investor divide his investment funds into two portfolios,
one aggressive and the other conservative or defensive. The aggressive policy usually consists of equity
shares while the defensive portfolio consists of bonds and debentures. The formula plans specify
predetermined rules for the transfer of funds from the aggressive portfolio to the defensive portfolio.
These rules enable the investor to automatically sell shares when their prices are rising and buy shares
when their prices are falling.

Assumptions of the Formula Plan

(i) Assumption I: Certain percentage of the investor’s fund is allocated to fixed income securities and
common stocks. The proportion of the money invested in each component depends on the

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 prevailing market condition. If the stock market is in the boom condition lesser funds are allotted
to stocks. If the market is low, the proportion may reverse.
(ii) Assumption II: If the market moves higher, the proportion of stocks in the portfolio may either
decline or remain constant. The portfolio is more aggressive in the low market and defensive when
the market is on the rise.
(iii) Assumption III: The stocks are bought and sold whenever there is a significant change in the
price. The changes in the level of market could be measured with the help of indices.
(iv)Assumption IV: The investor should strictly follow the formula plan once he chooses it. He should
not abandon the plan but continue to act on the plan.
(v) Assumption V: The investor should select good stocks that move along with the market. They
should reflect the risk and return features of the market.

Advantages of the Formula Plan

(i) Basic rules and regulations for the purchase and sale of securities are provided.
(ii) The rules and regulations are rigid and help to overcome human emotion.
(iii) The investor can earn higher profits by adopting the plans.
(iv)A course of action is formulated according to the investor’s objectives
(v) It controls the buying and selling of securities by the investor.
(vi)It is useful for taking decisions on the timing of investments.

Disadvantages of the Formula Plan

(i) The formula plan doesn’t help the selection of security.
(ii) The selection of the security has to be done either on the basis of the fundamental or technical
analysis.
(iii) The formula plan should be applied for long periods; otherwise the transaction cost may be
high.
(iv)Even if the investor adopts the formula plan, he needs forecasting. Market forecasting helps him to
identify the best stock.

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