KJ 3 BX

Capital Market and
Portfolio Management
S. No Reference No Particulars Slide
From-To
1 Chapter 1 Principles and Concepts of 4-28
Investments
2 Chapter 2 Return on Investment 29-53
3 Chapter 3 Risk and Return of Portfolio 54-77
4 Chapter 4 Diversification of Risk 78-101
5 Chapter 5 Modern Portfolio Theory 102-125
6 Chapter 6 Asset Pricing Principles - I 126-145

7 Chapter 7 Asset Pricing Principles - II 146-163
8 Chapter 8 Portfolio Analysis Techniques 164-198

9 Chapter 9 Efficient Market Theory 199-222
10 Chapter 10 Evaluation of Portfolio 223-246

Performance
Course Introduction
• For both an individual investor and an organisational investor, it is imperative to

understand the capital markets.
• Investors like to hold their portfolios at an optimum level.
• For making investments, the investors may use various methods and techniques.
• A thorough study of the capital markets and the methods and techniques of the
portfolio management help the investor to understand what investment
opportunities exist, make sound investment decisions, understand where the
problems related to investments may arise and how to resolve these problems.
• The study of capital markets and portfolio management helps the investor to
make real-world investment decisions.
Chapter 1: Principles and
Concepts of Investments
Chapter Index

From-To
1 Learning Objectives 7
2 Topic 1 Introduction to Investment 8-10
3 Topic 2 Introduction to Financial 11-14

Instruments
4 Topic 3 Marketable Financial 15

Instruments
5 Topic 4 Nonmarketable Financial 16-17

Instruments
6 Topic 5 Money Market and Capital 18-19

Market
Chapter Index

From-To
7 Topic 6 Stock and Bond Market Indexes 20-21
8 Topic 7 Investing in Financial Assets 22
9 Topic 8 Trading Mechanics 23-25
10 Let’s Sum Up 26
• Explain the basic concepts of investment
• Describe the various types of financial instruments
• Explain the marketable financial instruments
• Discuss the non-marketable financial instruments
• Describe what money market and capital market are
• Explain stock and bond market indices
• Discuss the concept of investing in financial assets
• Explain the trading mechanics

1. Introduction to Investment
• Investment refers to the process of deploying money, finances or funds with the
expectation of getting returns in due course of time.
• Making an investment requires an individual or organisation to choose from

among a whole gamut of investment options such as a pension fund, mutual
funds, fixed income securities, etc. It requires some analysis or thought to invest
money in a vehicle, instrument or asset, such as property, commodity, stock, bond,
financial derivatives, etc.
• When an asset is bought, there is anticipation that some return will be received
from the investment in the future. Investment is related to saving or deferring
consumption.
Investment Process
The investment process is a complex process as there are several points that the
investor needs to consider while making an investment. Some of these points are:
• The investor must take a decision on how much funds should be invested.
• The investor must decide on how much of the total funds to be invested should be
allocated to various schemes. For this an investor might also take the services of
a portfolio manager or an investment advisor as any wrong step at this stage may
result in losses.
• The investor must take into consideration the risk factor of the various schemes
in which he/she will be investing the funds.
Factors Affecting Investment Decision

The major factors that impact the decision of an investor are:
• Education about investment: An investor must be educated or must have some

knowledge about investment and how it can help him/her utilise money and
finances effectively. The investor must also have the habit of saving money as a
reckless and spendthrift person will not be able to invest wisely
• Risk tolerance of the investor: It is important to understand the amount of the

risk that an investor can bear as all investment schemes carry some form of risk
with them.
1. Introduction to Financial Instruments
Money as a Medium of Exchange
• Money has three properties that make it desirable to use it as a medium of

exchange. Money provides:
– A means of payment
– A unit of account
– A store of value
Stocks and Bonds

• Stocks and bonds are the two main classes of financial instruments investors use
in their portfolios.
• Stocks offer an ownership in the stake of an organization, while bonds are similar
to loans made to an organisation.
• In general, stocks are considered riskier and more volatile than bonds. However,
there are many different kinds of stocks and bonds, with varying levels of
volatility, risk and return.
Debt Instruments
• A debt instrument is a document that serves as a legally enforceable evidence of
debt and the promise of its timely repayment. In general, two terms are used for
denoting a debt instrument. These terms are bond and debentures.
• Debt market is basically a wholesale market wherein the trading of securities

takes place between the big institutional investors. These investors include
banks, financial institutions, mutual funds, provident funds, etc.
Derivatives
• Derivative can be referred to as a financial instrument whose value is derived
from the value of one or more basic variables, called bases (underlying asset,
index, or reference rate), in a predetermined manner. The underlying asset could
include equity, forex, commodity, etc.
• Debt market is basically a wholesale market wherein the trading of securities

takes place between the big institutional investors. These investors include
banks, financial institutions, mutual funds, provident funds, etc.
Marketable Financial Instruments
• Marketable financial instruments are the instruments which can be easily traded
in an organised financial trading system such as a stock exchange. The main
feature of the marketable financial instruments is the convenience with which
they can be converted into cash when needed by the investor.
• Marketable securities can be classified into two groups:
– Marketable equity securities: These include shares of common stock and

most preferred stock which are traded on a stock exchange and for which
there are quoted market prices.
– Marketable debt securities: These include government bonds and corporate

bonds which are traded on a bond exchange and for which there are quoted
market prices.
1. Nonmarketable Financial Instruments
• Non-marketable financial instruments are the instruments, which are very

difficult to trade in an organised financial market.
• These are risk free and safe investments which are traded in transactions of
private in nature.
• It is difficult to find a potential buyer for non-marketable securities.

2. Nonmarketable Financial Instruments
Different types of Nonmarketable securities:
• Savings account: They are a form of non-marketable securities that earn an

interest over a period. The interest rates and maturity period depends on the
banks.
• Government savings bonds: These are the tax certificates issued by the government
at a specific rate of interest on the invested amount. Government bonds that cannot
be traded in the open market constitute a part of government savings bonds. These
government debt instruments are traded amongst investors and financial
institutions (banks) indirectly.
1. Money Market and Capital Market
• Money market refers to the market where borrowers and lenders exchange short-
term funds to solve their liquidity needs. Short term refers to a period which is less
than one year. Money market instruments are generally financial claims that have
low default risk, maturities under one year and high marketability.
• Capital market is a market where stocks, shares and bonds are traded in the
market which is generally a stock exchange. The capital market is a market for
financial investments that are direct or indirect claims to capital.
2. Money Market and Capital Market
The main functions of money market are:
• Money market fulfils the short-term finance requirement of trade and industries
using bills of exchange, commercial papers, etc.
• It provides a mechanism through which the monetary policy of the government can
be implemented effectively.
• Money market allows the commercial banks to invest their excess reserves in an
investment so as to make profit and maintain liquidity of cash at any uncertain
demand of account holders. This also helps these banks to become self-sufficient in
terms of availability of funds.
1. Stock and Bond Market Indexes
• A stock index is a numeric value that is used to indicate the value of a particular
portion or segment of the stock market. It is computed by calculating the prices of
certain stocks which are picked up on a defined criterion or index. This index is
used by investors and financial advisors to guide the people in investing their
money wisely. The indexes are of various types and are based on the certain
parameters.
• Some of the stock market indices are as follows:
- Dow Jones Industrial Average:
- The S&P 500 Index:
- The National Association of Securities Dealers Automated Quotations

2. Stock and Bond Market Indexes
• Bond index is computed on the basis of bonds selected according to certain

parameters. The bond index assists the investors in deciding the future course of
action on the money they have invested.
• Some of the bond indices are discussed as follows:
- Barclays Capital Aggregate Bond Index:
- Salomon Broad Investment Grade (BIG) Index
- Merrill Lynch Domestic Master
- JPMorgan Emerging Market Bond Index (EMBI)

Investing in Financial Assets
• A financial asset is an asset whose value is based on some contractual entity. For
example, stocks, bonds, bank deposits and other instruments are financial assets
and have a legal identity.
• Investing in financial assets requires careful consideration of the following

factors:
Factors
Market Nature of Impact of

Risk Involved
Dynamics Economy Global Forces
1. Trading Mechanics
• Trading mechanics is the process of buying and selling of stocks from the stock
exchanges.
• Trading mechanics involves the following steps:
1. Place an order
2. Order match
3. Breaking up of orders
4. Modify orders
• In India, the trading in the stock market takes place on two stock exchanges,
namely the Bombay Stock Exchange (BSE) and the National Stock Exchange
(NSE). Both of these stock exchanges follow same trading mechanism, trading
hours, settlement process, etc. All the important and significant organisations of
India are listed on both of these exchanges.
• Trading at both BSE and NSE takes place using an open electronic limit order
book. This book is used for matching order with the help of trading computer.
This electronic system has removed the market makers or specialists from the
stock markets and the whole process has become order-driven, which implies that
the market orders placed by the investors can be matched automatically with the
best limit orders. Such a market helps in bringing as all the orders placed are
visible in the trading system.
• Trading mechanism of some securities and assets.
• Equity trading: It refers to the purchase and sell of an organisation’s stock

shares. In case of large companies, the equity trading takes place through the
stock exchanges like New York Stock Exchange, Bombay Stock Exchange, etc.
These exchanges act as managed auctions for stock trades. On the other hand,
small companies trade their shares in Over-The-Counter (OTC) markets, which
are the markets in which the securities of those companies are traded that are
not listed on the stock exchanges.
• Derivative trading: It involves the trading of various derivatives like spot,

futures, forwards, options, and swap in the FOREX market. FOREX market
includes a set of institutions like commercial banks, central banks, investment
bankers, MNCs, hedge funds, dealers, brokers and retailers.
Let’s Sum Up
• Investment refers to the process of deploying money, finances or funds with the
expectation of getting returns in due course of time.
• A financial instrument is a tradable asset of any kind. Financial instruments are

key components of the modern financial market system as they allow for efficient
flow of capital through the global financial market place.
• Money acts as is a medium of exchange in the process of investment. It is through

money that an exchange takes place. Every investment can be reduced to a
monetary value, which helps the investor in deciding whether to make an
investment or not.
• Stocks offer an ownership in the stake of an organization, while bonds are similar
to loans made to an organisation.
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Chapter 2: Return on
Investment
Chapter Index

From-To
2 Topic 1 Concept of Probability 33-35
3 Topic 2 Return on Investments 36-39
4 Topic 3 Selecting the Optimum Portfolio 40-41
5 Topic 4 Return on Common Stocks 42-44
6 Topic 5 Estimating Expected Returns 45-47

Chapter Index

From-To
7 Topic 6 Stock Return Distribution 48-50
8 Let’s Sum Up 51
• Understand the basic concepts of return on investment
• Explain the basic concepts of probability
• Explain how an optimum portfolio can be selected
• Understand the concept of return on common stocks
• Exemplify the concept of estimating the expected returns
• Understand the concept of stock return distribution

1. Concept of Probability
• The concept of probability is always associated with the return on investment as

the future prospects of investment can be predicted by analysing the current
situation and the trends as well.
• For example, an investment of Rs. 60 lakhs on a property could fetch a profit of

Rs. 10 lakhs can be anticipated by analysing the trend of increase in property
rates over the past few years and the current situation of the property market.
• However, probability does not ensure the expected returns and the property may
or may not be sold at the expected price.
Expected Value
• Expected value is the benefit which an investor anticipates by investing his
funds. It is the weighted average or the mean of probability distribution of the
possible future benefits that can be derived out of a scheme of investment. The
expected value is also known as the expected value of return on the portfolio
when we talk in terms of a portfolio. The formula for calculating expected value
is:
Where, E(R) = Expected return
Pi = Probability of asset i
Ri =Return on asset i
n = Number of assets in the portfolio

Variance
• Variance is used to measure the degree of risk in an investment. It is calculated
by finding the average of the squared deviations from the mean rate of return.
• The formula for calculating variance is:
∑(𝑋 − 𝑋)ത 2
2
𝜎 =
(𝑛 − 1)
where, X = Return from the asset
𝑋ത = Mean or Average rate of return
n = number of times the return is obtained

1. Return on Investments
Two Components of Return

• Return is not just the amount of dividend that a person receives on investment.
It also includes the price growth or the capital appreciation of the stock that
occurs over a period of time. Therefore, for making an investment both dividends
and price growth should be considered while calculating the Rate of Return.
Total Return
Capital
Income
Appreciation
Measuring Returns
• It is important for an investor to know how much returns he can get by investing
in an asset.
• For this purpose, the investor needs to measure the expected returns from the
asset.
• Some of the measures are return on investment, risk premium, expected return,
benchmark portfolios, holding period return, and excess returns.
There are various measures that help in determining the returns from an asset:
• Return on investment (ROI): This measure uses the all the cash flows generated
from an asset to determine the expected return on it. These cash flows include
dividends, interest, return of principal and capital gains.
• Risk premium: Risk premium is the high returns obtained by an individual by

investing in a growth stock having high risk, versus a stock from the stock of a
more established company.
• Expected return: It is the mean of the probability of possible rates of return.

Expected return is used for predicting the future value of a portfolio and also act
as a guide for measuring actual returns.
• Benchmark portfolios: In this measure, the portfolios are compared with a

benchmark, such as an index, for determining the expected return from an asset
• Holding period return: It is the return get by an investor for the time period he
has held the stocks. It is a good measure of return for short-term investments.
However, the variability in return from a stock is highly affected by the holding
period. If the holding period is short, the variability in the returns from stock will
be more and vice versa.
• Excess returns: It is the amount of return get by an investor above the expected
return on the basis of the beta of the stock or portfolio.
1. Selecting the Optimum Portfolio
• Irrespective of the type of investor, the optimum portfolio means that the investor
expects the highest level of returns on his investment and he wishes to minimize
the risk.
2. Selecting the Optimum Portfolio
• For selecting an optimum portfolio, an investor needs to evaluate the portfolio

based on two aspects, namely technical aspect and personal aspect.
• These two aspects are:
– Technical aspect
– Personal aspect
1. Return on Common Stocks
• Return on common stocks or equity (ROE) refers to the profit generated by an

organisation with the money invested by the common shareholders.
Net Income
ROE = ∗ 100
Average Common Stockholders′ Equity
• For example, assume that ABC Ltd. Earned a net income of Rs.4, 22,000 ending
march 31, 2014. The shareholders' equity on April 30, 2013 and March 31, 2014
was Rs.16,58,000 and Rs. 16,33,000 respectively. Calculate its ROE for the year
ending March 31, 2014.
• Average Shareholders' Equity = (Rs. 16,58,000 + Rs. 16,33,000 ) / 2 = Rs.

16,45,500
• Therefore, ROE = 4,22,000 / 16,45,500 ≈ 0.25 or 25%

Some key points related to return on equity are:
• The weighted average of the number of shares during a year is used for ROE
calculation, if new shares are issued.
• High growth companies give a higher return on equity.
• The average return on equity for past 5 to 10 years gives a better idea of the
historical growth
• ROE depicts how much net income is earned by an organisation from the capital
invested by the common stockholders.
• ROE is considered as a measure of profitability from the perspective of common

stockholders’, who are regarded as the real owner of an organisation.
• A high ROE shows that the profitability of the organisation is high. In addition, it
also represents the strong financial position of an organisation in the market.
1. Estimating Expected Returns
Aggregate Asset allocation

• Aggregate asset allocation involves the estimation of amount or proportion of
capital needs to be invested in different categories of securities, such as
government securities, corporate bonds, international stocks, etc.
• An investor needs to determine the allocation of money in different securities in

order to generate maximum returns.
• For example, an individual wants to make investment in order to secure his

future after retirement. He needs to make pension plan, wherein he needs to
decide how much investment he needs to make in each asset category. This is
basically called aggregate asset allocation decisions that are made based on the
expected returns from each asset category.
2. Estimating expected Returns
Asset Allocation Strategies:
Asset Allocation Strategies Strategic Asset Allocation
Tactical Asset Allocation
Core-Satellite Asset Allocation
Systematic Asset Allocation

3. Estimating expected Returns
Aggregate Asset Allocation

Asset allocation strategies:
• Strategic Asset Allocation: In this strategy, the objective of the investor is to have
an asset mix that provides him/her the optimal balance between the expected risk
and return for a long-term period.
• Tactical Asset Allocation: Investors adopting this strategy try to have an asset
mix of securities that are expected to provide high returns.
• Core-Satellite Asset Allocation: This strategy is basically the hybrid of both

strategic and tactical asset allocation strategies.
• Systematic Asset Allocation

1. Stock Return Distribution
• The process where determining the distribution of funds in various stocks gives a
clarity on pattern of return generated.
• The distribution might be normal, or a logarithmic. By understanding the pattern

of distribution and the returns, an investor can plan investment in better way.
• The two types of distributions are:

Types of distributions
Normal
distribution
Lognormal
distribution
• Normal distribution: The normal distribution was introduced by Karl Guass.
• The normal distribution is a model of continuous distribution. A normal random

variable is capable of assuming any value on the real number line.
• The characteristics of a normal distribution are as follows:
– A bell shaped and symmetrical distribution.
– In normal distribution, the mean, median and mode lie in the centre and
have the same numerical value.
– The curve of normal distribution is asymptotic to the horizontal axis.
– It is completely defined by two parameters, namely mean (µ) of probable rate

of returns (i.e. expected rate of return) and standard deviation (σ), which is
the risk associated with an asset.
• Lognormal distribution: It is widely used in finance as it is assumed by many

investors that stock prices are distributed lognormally. This distribution is non-
zero and is skewed on the right side of the graph, which implies that the price of
a stock cannot fall below zero but it can go as high as possible.
• While the stock returns generally have a normal distribution, the stock price
itself is often log-normally distributed. This happens due to the fact that extreme
moves become less frequent as the stock prices approach zero.
• The distribution of stock prices and returns helps investors to determine the
probable gains and losses in their portfolio. If most stocks in the investor’s
portfolio exhibit large moves on both the up and the down side, the potential
gains as well as losses would be large.
Let’s Sum Up
• The concept of probability is always associated with the return on investment as

the future prospects of investment can be predicted by analysing the current
situation and the trends as well.
• Expected value is the benefit which an investor anticipates by investing his

funds. It is the weighted average or the mean of probability distribution of the
possible future benefits that can be derived out of a scheme of investment.
• Variance is used to measure the degree of risk in an investment.
• ROI depends on the amount of investment made in a company stock or elsewhere

and on the net profit of the business in which the investment is made.
Post Your Query
Chapter 3: Risk and
Return of Portfolio
Chapter Index

From-To
2 Topic 1 Portfolio Return - The Case of 57
Two Assets
3 Topic 2 Expected Return and Variance 58-61
Analysis of Returns- The Case of
Two Assets
4 Topic 3 Portfolio Risk and Return 62-68
Analysis
5 Topic 4 Measuring Risk 69-72
6 Topic 5 Portfolio Risk - The Case of Two 73

Assets
7 Topic 6 Portfolio Risk - The N-Asset 74
Case
8 Let’s Sum Up 75
• Explain the concept of portfolio return in case of two assets
• Calculate expected return and variance analysis of returns
• Explain portfolio risk and return analysis
• Perform risk measurement
• Explain portfolio risk
• Explain portfolio risk in N-asset case

Portfolio Return - The Case of Two Assets
• In order to understand portfolio structure it is imperative to consider the impact

of combining two assets to form a portfolio.
• If w1and w2 are the proportions invested in assets 1 and 2 respectively and r1 and
r2 will be their expected returns. Then, the expected return of the portfolio ‘E(P)’
will be:
E (P) = w1*r1 + w2*r2
• The sum total of the proportion of investments will be 1.

1. Expected Return and Variance Analysis of Returns-
The Case of Two Assets
• The variance of a portfolio is a measure of dispersion of the expected return. In

simple terms, we can say that the variance gives an idea of range or dispersion by
which amount the expected return may vary.
• The variance of a portfolio's return is a function of the variance of the individual

assets in the portfolio and the covariance between each of them.
• Covariance is a measure of the movement of two or more assets with respect to

each other. Covariance may be negative, positive or zero.
• A positive covariance indicates that the return on assets move together. A

negative covariance means returns move vice versa. A Zero covariance indicates
that there is no correlation among the two assets.
• The variance of the portfolio, σ2, depends on the proportions invested in the
different assets, the variances of their return (σ12 and σ22) and the covariance
between their returns is cov(1,2):
• σ2 = w12 σ12 + w22 σ22 + 2 w1 w2 Cov(1,2)

Where,
– w1 = Weight of Asset 1 in the portfolio
– w2 = Weight of Asset 2 in the portfolio
– σ12 = Variance of Asset 1 in the portfolio
– σ22 = Variance of Asset 2 in the portfolio
– Cov(1,2) = Covariance of asset 1 and asset 2

Example:
• Assume that an investor invests his funds in ratio of 3:2 (60%-40%) in two assets
1 and 2. Also, the expected return of asset 1 is 9.95%, expected return of asset 2 is
19. 00%, Standard Deviation of asset 1 is 16%, Standard Deviation of asset 2 is
34%, and Covariance of asset 1 and asset 2 is 0.0064.
• Expected return of the portfolio is calculated as:
– E (P) = w1 r1 + w2 r2
– E (P) = 0.6 * 0.0995 + 0.4 * 0.19
– E (P) = 0.0597 + 0.076
– E (P) = 0.1357 = 13.57%

• Variance of the portfolio is calculated as:
σ2 = w12 σ12 + w22 σ22 + 2 w1 w2 Cov (1, 2)
σp2 = ((0.6)2 (0.16)2) + ((0.4)2 (0.34)2) + 2 (0.6) (0.4) (0.0064)
σp2 = 0.009216 + 0.018496 + 0.003072
σp2 = 0.030784 = 3.07%
• Standard deviation of the portfolio:
σp = √σp2
σp = √0.030784
σp = 0.1754
σp = 17.54%
1. Portfolio Risk and Return Analysis
• The expected return of portfolio is computed by taking the weighted average of

the expected return of the stocks in the portfolio.
• The weighted average of the likely profits of the assets in the portfolio, weighted
by the likely profits of each asset class.
• Expected return of portfolio is computed by using the following formula:
E(R) = w1R1 + w2R2 + ...+ wnRn
• Example: Consider the case of a portfolio in which we have two assets namely
mutual fund investing in bonds and mutual fund investing in stocks. The
expected return on bond based mutual fund is 8% and the expected return from
the stock based mutual fund is 10%. The investment is divided among the two
assets in proportion of 70%-30%.
• Therefore, for this situation, the expected return would be:
E(P) = w1R1 + w2R2
E(P) = (0.7 * 0.08) + (0.3 * 0.10)
E(P) = 0.056 + 0.03
E(P) = 0.086 = 8.6%
• Expected return is, by no means, an assured rate of return. Yet, it can be used to
predict the future value of a portfolio.
Portfolio Variance
• The variance of a portfolio is the measure of the volatility or the risk

associated with it.
• Portfolio variance takes into account the standard deviation of each asset of
the portfolio as well as the covariance of each asset of the portfolio with the
others. The lower the covariance among the assets of the portfolio, the lower
would be the portfolio variance.
• A positive covariance indicates that the return on assets move together.
• A negative covariance means returns move contrary.
• A Zero covariance indicates that there is no correlation among the two assets.
Portfolio Variance
• Covariance is expressed as:
n
Cov (A, B) = {∑ (RA – (R’A)) i * (RB – (R’B)) i} / (n -1)
i=1
Where,
Cov (A, B) = Covariance of asset A and asset B
RA = return on asset A for period i
RB = return on asset B for period i
R’A = Average of all the returns of asset A over the entire period
R’B = Average of all the returns of asset B over the entire period
n = no. of periods
Example: Assume that there are two stocks S1 and S2, there closing price data
for 5 days is shown below:
Day S1 return (%) S2 return (%)
1 1.2 3.3
2 1.8 4.1
3 2.2 4.8
4 1.3 4.0
5 0.25 2.56
Now, let us calculate the average return for each stock:
For S1, average return = (1.2 + 1.8 + 2.2 + 1.3 + 0.25) / 5 = 1.35
For S2, average return = (3.3 + 4.1 + 4.8 + 4.0 + 2.56) / 5 = 3.752
The covariance for the above example is calculated as:
= [(1.2 - 1.35) x (3.3 - 3.752)] + [(1.8 - 1.35) x (4.1 -3.752)] + [(2.2 - 1.35) x (4.8 -
3.752)] + [(1.3 - 1.35) x (4.0 - 3.752)] + [(0.25 - 1.35) x (2.56 - 3.752)] / (5-1)
= [(-0.15 × -0.452) + (0.45 × 0.348) + (0.85 × 1.048) + (-0.05 × 0.248) + (-1.1 × -

1.192)]/4
= [0.0678] + [0.1566] + [0.8908] + [- 0.0124] + [1.3112] / 4
= 2.414 / 4
= 0.6035
Standard Deviation
Standard deviation can be defined as follows:
1. A measure of the dispersion of a set of data from its mean. It indicates

about the level of volatility of the asset
2. The square root of variance. The higher the dispersion, the higher is the
standard deviation.
Example: Standard deviation (σ) is calculated by taking the square root of

variance. Assume that the variance of an asset is 144 then the standard
deviation of that asset will be:
1441/2 = 12.00%.
1. Measuring Risk
• The expected return of a portfolio is the weighted average of the individual

returns.
• In case of risk the expected risk of portfolio, it is not the weighted average of the
individual assets in the portfolio. The overall risk of the portfolio depends on the
type of assets that comprise the portfolio.
• We can obtain a lower level of overall risk of the portfolio if we combine the assets
ranging from risk-free or risk-less assets to the extremely risky assets in some
fixed proportion.
• Two concepts related to portfolio risk are variance and standard deviation.
2. Measuring Risk
• Three indicators of investment risks apart from variance and standard deviation
that are used to predict the volatility and return of a portfolio are:
• Beta: Beta is the measure of volatility of an individual security or the portfolio as

a whole compared to the market as a whole. Beta is calculated using the
regression analysis. The value of beta is an indicator of the stock movement with
regards to the entire market.
• Alpha: Is the measurement of stock price volatility based on the specific

characteristics of the specific security. Alpha is a measure of performance of a
stock or portfolio on a ‘risk-adjusted basis’.
3. Measuring Risk
• Sharpe ratio: Is a complex measurement that utilises the standard deviation of a

portfolio or stock to measure volatility. Greater is the Sharpe ratio, more is the
potential return. Sharpe ratio is an indicator of stock performance taking into
account the risk associated with it. It measures the excess return or the risk
premium, per unit of deviation in the stock or portfolio. It is calculated using the
formula mentioned below:
Sharpe Ratio = (total return - risk free rate of return) / standard deviation
of portfolio
4. Measuring Risk
Correlation Coefficient
• Correlation coefficient is the measure of the degree of two variables with respect
to each other.
Risk Premium
• Risk premium can be defined as the return in excess of the risk-free rate of
return that an investment yields. An asset's risk premium is a kind of
compensation for investors who bear the extra risk - compared to that of a risk-
free asset in a given investment.
Portfolio Risk - The Case of Two Assets
Case 1: In case of two risky assets with perfectly positive correlated returns: The
efficient frontier is linear. In this case, the two assets are identical and there would
be no benefit from diversification. Here, σ𝑅 = w1σ1 + (1-w1)σ2
Case 2: In case of two risky assets with imperfectly correlated returns: The standard
deviation of the portfolio is smaller than it would have been in case the two assets
were perfectly correlated. Here, σ𝑅 < w1σ1 + (1−w1)σ2
Case 3: In case the two risky assets are perfectly negatively correlated. The
minimum variance portfolio is risk free while the efficient frontier is again a straight
line.
Case 4: In case one of the two assets is risk free: In this case the efficient frontier is a
straight line originating on the vertical axis at the level of the risk free return
Portfolio Risk - The N-Asset Case
• For an N asset portfolio, the portfolio return is only the sum of the asset returns
multiplied by the weights each of the assets that are in the portfolio.
• E(R) = w1R1 + w2R2 + ...+ wnRn
Where,
Wn = Weight of security n
Rn = Return on security n
Let’s Sum Up
• Portfolio return can be defined as the financial return received by a portfolio

holder. You can compute expected return as the weighted average of the likely
profits of the assets in the portfolio, weighted by the likely profits of each asset
class.
• Variance, denoted by σ2 , is a measure of the dispersion of a set of data points

around their mean value.
• Volatility is referred as a measure of risk. This term can help you to measure the
risk that an investor might take on while buying a particular security.
• Correlation Coefficient, which is a statistical concept, is sometimes also called the

cross-correlation coefficient. It is a measure of the degree to which movements of
two variables are associated.
Post Your Query
Chapter 4: Diversification
of Risk
Chapter Index

From-To
2 Topic 1 Systematic and Unsystematic 81

Risks
3 Topic 2 Risky and Risk Free Assets 82-85
4 Topic 3 Sharpe Portfolio Optimisation 86-88
5 Topic 4 Significance of Beta 89-92
6 Topic 5 Traditional Portfolio Selection 93-95
7 Topic 6 Mutual Funds for Risk 96-98

Diversification
8 Let’s Sum Up 99
• Describe systematic and unsystematic risks
• Explain risky and risk-free assets
• Discuss Sharpe portfolio optimisation
• Explain the significance of Beta
• Discuss traditional portfolio selection
• Discuss the role of mutual funds in risk diversification

Systematic and Unsystematic Risks
• Risk can be broadly categorised in systematic and unsystematic risks. There are
some risks that are not specific to any company or industry. However, there are
certain risks that are present in the entire industry or market.
• Unsystematic risks are those risks that are specific to any industry or company.
For example, news that there is a labour dispute in a factory of company can
significantly impact the share price of the specific company and not the entire
market. This is the reason unsystematic risk is also called “specific risk” or
“diversifiable risk”.
1. Risky and Risk Free Assets
• Any investor would like to receive the highest possible return from a given risk
level that he/she is wants to take.
• The highest possible return from an investor’s risk level can be achieved by
maximising return with the help of a portfolio that consists of 2 types of assets.
These assets are a risk free asset (having no risk and a significantly low return)
and a risky asset (having high risk and high expected return).
• We can measure investment risk from the standard deviation of investment

returns. Naturally, higher risk is associated with higher standard deviation.
• The investor can earn a low return without any risk by putting his /her entire
funds into the risk-free asset. The investor can also earn the maximum return by
allocating his/her entire funds to the risky asset.
Capital Market Line (CML)

• In a portfolio consisting of two portfolios, the return depends on the proportion of
the risky and risk-free asset in the portfolio. If the proportion of the risky asset in
the portfolio is y. Therefore, the portfolio return would be given by:
• Portfolio Return = y*risky asset return + (1-y)*risk-free return.
• The total risk involved in the portfolio can be varied by changing the proportion
of the two types of assets in the portfolio. The different possible combinations of
the risky and risk-free assets constitute a set called investment opportunity set.
Capital Market Line (CML)

• The investment opportunity set can be graphed as a line when we plot return
against risk in the portfolio.
• We can measure risk with the help of standard deviation. This line is called
Capital Allocation Line (CAL).
• The starting point of the capital allocation line is where the combination of
minimum return and no risk given by the risk-free asset and the maximum
return and risk of the risky asset intercepts. Therefore, we can say that the CAL
depicts the different possible combinations of the risky and the risk-free asset.
• In case the risky asset provides a market return instead of a single-asset return,
the CAL formed is called Capital Market Line (CML).
Combining a Risky and Risk Free Asset
• We know that a risk-free asset has zero variance or standard deviation. Suppose
an investor invests in a risk-free security `f` providing 10% return and a risky
security `r` having 30% returns. The risky asset has a standard deviation of 6%.
Let us calculate the portfolio return and risk in case the investor invests in these
two securities in equal proportion. The portfolio return would be:
– E(Rp)= wE(Rr) + (1-w)Rf
– = 0.20 0r 20%
• The value of the covariance between the risky and risk-free security would also
be zero. Therefore, the portfolio risk would be the equal to the standard deviation
of the risky security and its weight.
1. Sharpe Portfolio Optimisation
• After selecting the stocks for investment, the next step is to allocate assets. There
are a number of asset allocations strategies. The Sharpe portfolio optimisation is
a strategy that uses Sharpe ratio for allocating assets.
• Higher Sharpe ratio indicates higher returns form a fund relative to the risks
involved.
• We can use the ratio to compare risk adjusted return of various funds with the
help of Sharpe ratio.
• It was named after Nobel Laureate William Sharpe.

• Sharpe ratio does not guarantee highest return or lowest risk.
• It is a strategy that helps in selecting the effective ways of managing risk.
• We can calculate the Sharpe ratio with the help of expected return and standard
deviation, and the risk free rate
Sharpe Ratio = ( rx – Rf ) / StdDev(x)
Where,
rx refers to the average yearly interest rate given by the asset x.
Rf refers to the risk-free rate.
StdDev(x) refers to the standard deviation of return of asset x.

• Stock Sharpe Ratio
P1 1.5
P2 2
P3 2.5
• Total of Sharpe Ratios 6.0
• Now divide the Sharpe ratio of the individual stocks by the total of the Sharpe
ratios:
• 1) For P1: 1.5/6 = 0.25
• 2) For P2 : 2/6 = 0.33
• 3) For P3 : 2.5/6 = 0.42
• For optimum portfolio (minimum risk and maximum retrun) invest 25% in asset
P1 , 33% in asset P2 , and 42% in asset P3.
1. Significance of Beta
• Beta is a measure of systematic risk of an asset or a portfolio compared to the

systematic risk in the entire market. Therefore, we can say that beta informs an
investor about the risks involved in a stock and the risk involved in the entire
market.
• Investment analysts use the Greek letter β to denote beta. Beta is extensively
applied in the Capital Asset Pricing Model (CAPM).
• Beta coefficient is computed by dividing the covariance of a market and stock

return variance of market return. Beta coefficient is given by the following
formula:
• β= Covariance of Market Return with Stock Return / Variance of Market

Return
Beta Estimation
• Beta is the tangent of the graph that we can obtain by plotting the time series of
returns of a portfolio (Rp) against the overall return from the market (Rm). The
Rm is plotted along the x-axis and portfolio return is plotted along the y-axis.
• The point where x and y axes intersect is called the cash-equivalent return by
which the returns are adjusted. The best-fit line which indicates the data point
helps to quantify both active and passive risk.
Beta Estimation
Beta in Stock Selection

• Investors take help of beta to select stocks.
• Optimistic investors tend to select securities with high beta value. This is because
these securities have a higher probability of giving better returns than the
market.
• an investor expecting the market to go down tends to select the securities of

which the beta is less than 1. This is because the value of these securities is
expected to decline less in value than the market index.
• If the beta of a portfolio is 0.5 and if Sensex declines by 10%, the stock will
decline by 5%.
1. Traditional Portfolio Selection
• The traditional portfolio method takes a logical approval of building portfolio by

evaluating the performance of a portfolio with the help of their mean and
variance.
• There are the two methods that are mainly used as traditional portfolio selection
methods:
Traditional
portfolio
selection
methods
Markowitz Sharpe Single

Portfolio Index Portfolio
Selection Selection
method Method
• Markowitz Portfolio Selection method: This portfolio selection method is also

known as Modern Portfolio Theory (MPT).
• Nobel Laureate Economist Harry Markowitz published an article titled portfolio

selection in 1952. He described his mathematic argument favouring portfolio
diversification. The basic premise of the MPT is that an investor can develop an
“efficient frontier” of optimal portfolios that would yield maximum possible
return for a given risk level.
• The main steps involved in the method are:
– Security valuation
– Asset allocation
– Portfolio optimisation
– Performance measurement
• Sharpe Single Index Portfolio Selection Method: This model was developed by
William Sharpe to simplify the Markowitz portfolio selection method.
• This model reduces the number of inputs required in the Markowitz model. The
model observes that most assets yield returns in relation to the overall yield in
the market.
1. Mutual Funds for Risk Diversification
• Mutual funds are great tools for diversifying portfolio and managing risks.
• Individual investors lack in professional knowledge.
• Mutual funds are managed by professionals who are well informed about the
technicalities of risk, return and other aspects of investment.
• The major types of mutual funds that help in diversifying risks are:
Equity-oriented Mutual fund

Major types of
mutual funds
Debt-oriented mutual funds
Gold savings funds or Gold ETFs
Real estate venture capital funds

• Equity-oriented Mutual fund: This fund helps in diversifying portfolio with the
help of various equity funds, such as large-cap, mid cap, multi-cap, and sectoral
funds.
• Debt-oriented mutual funds :These types of funds are made of debt products;
therefore, they provide a fixed return with very low risk level.
• Gold savings funds or Gold ETFs: Indians have cultural and emotional connection
with gold. Historically, gold is considered to be a very precious personal asset.
Gold ETFs provide a way of investing in gold and diversifying portfolio.
• Real estate venture capital funds: Current regulatory restrictions do not allow
mutual funds to directly invest in real estate. However, some mutual funds
houses have venture capital schemes for real estate investors. However, mainly
high net worth individuals invest in these funds because of the very high
minimum investment. Therefore, investors with sufficient funds and willing to
get exposure in the real-estate market with the help of professional management
can invest in such funds for portfolio diversification.
Let’s Sum Up
• Systematic risk is also known as market risk or volatility. Volatility is the reason
the share price can go in any direction.
• Unsystematic risks are those risks that are specific to any industry or company.
• In a portfolio consisting of two portfolios, the return depends on the proportion of

the risky and risk-free asset in the portfolio.
• In case the risky asset provides market return instead of a single-asset return,
the CAL formed is called Capital Market Line (CML).
• Beta is the measure of systematic risk of an asset or a portfolio compared to the

systematic risk of the entire market.
Post Your Query
Chapter 5: Modern Portfolio
Theory
Chapter Index

From-To
2 Topic 1 Utility Functions and 105-107

Indifference Curves
3 Topic 2 The Efficient Frontier 108-112
4 Topic 3 The Markowitz Model 113-120
5 Topic 4 Sharpe’s Single Index Model 121-122

 Explain various aspects of functions and indifference curves
 Describe the efficient frontier
 Discuss the Markowitz Model
 Describe the single index model of Sharpe
1. Utility Functions and Indifference Curves
• The utility function explains the point of function or contentment as a function of

the quantities of commodities consumed. The purpose embodies the customer’s
choices. In the utility function the dependent variable is utility, and the
independent variables are the amounts consumed of goods or services.
• An indifference curve demonstrates all of the amounts of commodities that

provide the customer the equal level of agreement.
• One can consistently refer to every point on the indifference curve as interpreting
the equal level of utility (contentment) for the customer.
• Utility is subsequently a tool to symbolise choices instead of something from

which the choices are derived.
Von Neumann-Morgenstern Expected Utility Hypothesis

• The hypotheses states that whenever a consumer needs to select different
outcomes, the occurrence of which are subject to different degrees of chance, the
choice will be the one for which the expected value of utility.
• It should be noted that here expected value of utility refers to the value that can
be obtained by multiplying the utilities of outcomes with their probabilities of
occurrence.
• Expected Utility Hypothesis states that companies or investors choose to

maximise expectation of utility rather than monetary values.
Shape of Portfolio Possibilities Curve

For portfolios consisting of two securities:
• The lower (closer to -1.0) the correlation coefficient between assets, all other
features held stable, the higher the payoff from diversification.
• Combinations of two assets can never have more threat than that found on a
straight line linking the two assets in expected return standard deviation space.
• There is a simple expression for locating the least variance portfolio when two
assets are linked in a portfolio.
• We can utilise these insights to increase more insight into the shape of the curve
along which every probable combination of assets must lie in expected return
standard deviation space. This curve is known as the portfolio possibilities curve.
1. The Efficient Frontier
• One of the most important assumptions of the Modern Portfolio Theory (MPT) is
that an investor must seek to minimise the volatility in a portfolio. Risk efficiency
is an important aspect of the MPT.
• In order to build an optimum portfolio, the low and high risk securities need to be
combined in such a way that the investor gets high return for a relatively low risk
level.
• This means the investor needs to settle for a low combined standard deviation
relative to the individual standard deviations of the securities. . This would result
in a higher average rate of return with relatively low harmful fluctuations.
• If an investor plots the average returns and the standard deviations of a set of
securities and the portfolios that can be developed after combining the securities,
it would result in a region bounded by an upward-sloping curve. Harry
Markowitz named this upward-sloping curve as efficient frontier.
Riskless Lending and Borrowing

• It is relevant in any type of business deal that there is a level of risk that could
show the way to unexpected losses to either party; specifically accurate in lending
or borrowing money.
• The borrower could evade on the loan for any number of causes, and the lender
could be left petite.
• The interest rate could also alter, demanding one of sides to get a diverse total
return on the deal than in real expected, which could have long term impacts.
Borrowing And Lending Through Treasure Bills

• The government, with treasury bills, is basically agreeing to borrow a specific
amount of money that it will compensate at the date of the bill's maturity. The
rate of return is programmed, so two sides understand what they are obtaining at
all times.
• The government is receiving the amount of money the lender utilises to buy the
bill, and the lender is obtaining the value of the bill at its maturity. The rate of
return for the lender is not subject to alteration with fluctuations in interest rate
or any other external aspects, so the transaction can be grouped as risk-free for
both the borrower and the lender.
Efficient Frontier
9.00
8.00
7.00
6.00
Standard Deviation
5.00
4.00
3.00
2.00
1.00
0.00
0.00 0.20 0.40 0.60 0.80 1.00 1.20 1.40 1.60
Average monthly return
1. The Markowitz Model
• Nobel Memorial Prize winning economist Harry Markowitz devised the modern
portfolio theory in 1952.
• Markowitz's hypothesis emphasised the relevance of portfolios, risk, the

correlations between securities and diversification. His work altered the manner
in which people invested.
• Before Markowitz's theories, investors focused on what was placed on picking

single high-yield stocks without any consideration to their impacts on portfolios
as a whole.
• Markowitz's portfolio hypothesis would be a huge initiative for the formation of

the capital asset pricing model.
Formulation of the Model

• Harry Markowitz model helps in the choosing the most effective portfolio by
observing different probable portfolios of the stated securities. By selecting
securities that do not 'move' precisely in concert, the HM model demonstrates
investors the method to lessen their risk.
• The underlying principle of the model is that the combined risk of two securities
would be different from the individual risk of the securities.
• The HM model is even known as Mean-Variance Model

• Major advantages of the model:
– It provides an effective mean of mitigating risks with the help of

diversification.
– It helps in quantifying the benefits of diversification of portfolio
• One important disadvantage of the model is that it is a complex model and

involves tedious calculations.
The Efficient Frontier Calculation Algorithm

• The Markowitz model is based on the assumption that portfolios face no
constraints. However, in reality there are many constraints that portfolios face.
For example, when short-selling is prohibited, it would be assumed by default
that all the assets are positively weighed.
• In order to decide a certain portfolio diversification, the amount invested per

security needs to be limited. Thus, it is necessary to integrate the different
constraints into resolution methods.
• Typically, constraints are represented as follows: ai ≤ xi ≤ bi, i = 1, …..,n
• The impossibility to short sells is due to a special case where, ai = 0 and bi = 1, i =

1, …..,n

• The investor’s objective function is given as a function of the investor’s aversion
to risk, represented as λ. Varying λ values, the characterisation of the complete
efficient frontier is obtained.
• If constraints exist on the portfolio, then for each value of λ, the solution would
have xi values equal to their lower limit, xi values located between their lower
limit and their upper limit and xi values having upper limits.
• Assuming that each variable is known, linear equations can be derived. The value
of each variable depends on the value of λ.

• For each variable, a critical value of λ exists, which can be calculated according to
the parameters of the problem.
• The critical λ thus obtained are sequenced together to give the resolution
algorithm. The resolution algorithm helps in finding the solution that is valid up
to the first critical λ. This is continued making necessary modifications each time
a variable changes status.
• The portfolios that correspond to the critical λ are referred to as “corner”

portfolios. These portfolios are sufficient for calculating the complete efficient
frontier.

• To compute the efficient frontier using n assets, we need to have two inputs:
1. Expected average return of the assets. We can denote the vector of expected
result as: 𝑧ҧ
2. The variance-covariance matrix for the n assets. We can designate the covariance
matrix as S. We even require a unity vector (1) with the similar length as the
vector, 𝑧ҧ
• When we have the data, we can run the below computations using a matrix
dependent on arithmetical program like Octave:
• Using these values, the variance at each level of expected return is given by this
equation.
• From the equation, you can see that the efficient frontier is a parabola in mean-
variance space. Using the standard deviation, rather than the variance, we have:
1. Sharpe’s Single Index Model
• Markowitz model states that diversification can reduce risk. However, there are a
number of limitations of this model which need to be resolved. One of the most
commonly cited difficulty of the model is that it involves increasingly complex
mathematical calculations as we increase the number of securities. Because of
this difficulty in calculation in this model, portfolio analysts avoid this model.
• In order to simplify the Markowitz model, William F. Sharpe developed the

Single Index Model (SIM). This model helps in estimating the returns of
securities as well as the value of the index.
2. Sharpe’s Single Index Model
• The Sharpe`s SIM expressed the return from an individual security as a function
of the return of the overall market index. This is shown in the following formula:
Ri = ai + biRM + ei
• Here, Ri refers to the return on security I, RM refers to the return on the market
index, ai refers to risk free return, bi is a measure of the sensitivity of the return
of the security ‘I’ with respect to the index return and ei refers to the error term.
• The single index model is a much simpler model than the Markowitz model. For
example, if an investor is calculating for n securities, the single index model
needs 3n+2 estimates; whereas the Markowitz model would require (n(n+3))/2
estimates.
Let’s Sum Up
• The portfolio theory is considered as an important tool by the risk-averse

investors to analyse the market threats, study the market benefits, and invest
and get the best profit through their investments.
• Utility is subsequently a tool to symbolise choices instead of something from

which the choices are derived.
• The important use of indifference curves is in the symbol of prospective apparent

demand outline for individual customers over commodity bundles. It is relevant
in any type of business deal that there is a level of risk that could show the way
to unexpected losses to either party.
• This is specifically accurate in lending or borrowing money. The government, with

treasury bills, is basically agreeing to borrow a specific amount of money that it
will compensate at the date of the bill's maturity.
Post Your Query
Chapter 6: Asset Pricing
Principles - I
Chapter Index

From-To
2 Topic 1 The Risk-Return Trade off 129-132
3 Topic 2 Capital Asset Pricing Model 133-142

(CAPM)

• Explain the concept of risk return off trade.
• Describe the security market line
• Explain the concept of CAPM

1. The Risk-Return Trade off
• Risk and return are two of the most important concepts in which investors are
interested. Return refers to the financial gain that can be received from an
investment. Risk refers to the degree of uncertainty that the actual return would
be different from the expected. This is calculated in statistics through standard
deviation.
• This phenomenon that probable return goes up with increase in risk is called
risk-return trade off.
Security Market Line (SML)

• Security market line is a line that shows the systematic or market risk against
the return of complete market at a particular period and displays all risky
market securities.
• Beta is the measure of risk used by the SML. The SML fundamentally shows the
results from the assets pricing model CAPM formula. The x-axis shows the risk
(beta), and the y-axis, the anticipated return.
• The line begins with a risk-free rate and then makes an upward-right movement.
• Risk-averse investors would like to invest towards the starting point of the SML
and high risk profile investors would like to select investments higher along the
SML.
Estimating Security Market Line (SML)

• If the security risk against the anticipated return is marked on top of SML, it has
no value since the investor can anticipate more return from the inbuilt risk. A
security marked below the SML is overrated since the investor could receive less
return for the level of risk assumed.
• The Y-intercept is equal to the risk-free interest rate. The SML slope is equal to
the market risk premium and shows the risk return trade off at certain given
time.
• Here, E(Ri) is an expected return on security, E(RM) is an expected return on

market portfolio M, β is a non-diversifiable or systematic risk, RM is a market risk
and Rf is a risk-free rate
Estimating Security Market Line (SML)

1. Capital Asset Pricing Model (CAPM)
Capital Asset Pricing Model (CAPM)

• The capital asset pricing model is a financial model being utilised to rate risky
securities, which explain the link between risk and anticipated return.
• It ascertains what the rate of return of an asset is going to be, presuming that it
is to be included to a well-diversified portfolio.
• The asset’s sensitivity is shown with quantity beta (β), and the expected return of
the market and the return of hypothetical risk-free asset.
Capital Asset Pricing Model (CAPM)

• CAPM supposes that each asset is accurately priced. In actual world applications,
it allows us to ascertain if a security is worthwhile investment or not by making
comparison of the expected rate of return of the security, given by the CAPM
equation, with the real rate of return.
• If the actual return is more than or equal to what is expected from CAPM, then
the investment should be considered.
Assumptions of CAPM
All investors:
• Aspire to exploit the monetary utilities.
• Are realistic and risk unenthusiastic.
• Are widely diversified across a series of investments.
• Are price absorbers, that is, they are not able to manipulate the prices.
• Are able to offer and use unlimited sum under risk-free rate of interest.
• Are trading without business or taxation rates.
• Are operating with securities which are highly separable into tiny packages.
• Presume all information is accessible to all investors at the same time.

Assumptions of CAPM
Systematic Vs. Unsystematic Risk
• Systematic risk which is known as market risk or non-diversifiable risk,

symbolises the risk present in the security connected to complete economy. For
example, the risk posed to all the securities in the market by various factors, such
as inflation, GDP rate, unemployment, and political stability is systematic risk.
• Unsystematic risk, which is also known an idiosyncratic risk or diversifiable risk,

symbolises the risk present in security particularly to that investment and
unrelated to the total risk of the market. For example, employee unrest in a
particular company would affect the stock price of that particular company and
not that of the entire market. Therefore, this is an example of unsystematic risk.
Assumptions of CAPM
Systematic Vs. Unsystematic Risk
• CAPM asserts that in market equilibrium, investors are only repaid for enduring
the systematic risk, the kind of risk which cannot be diversified.
• Investors should not be repaid for bearing unsystematic risk, as improbability

can be alleviated through accurate diversification.
CML vs. SML

• Capital Market Line (CML) refers to the tangent that can be drawn connecting
the point of the risk-free asset to the feasible region for risky assets.
CML vs. SML

Particular CML SML
Definition CML is a line which shows the rates SML, also known as Characteristic
of return, depending on risk-free rates Line, is an illustration of the
of return and levels of risk for a market’s risk and return at a
particular portfolio. specific time period.
Measure of Risk Standard deviation is the measure of Beta coefficient ascertains the risk
risk for CML. factors of the SML.
Graph CML graphs describe proficient SML graphs describe both
portfolios. proficient and non-proficient
portfolios, that is, the securities and
portfolios that show on top of SML
are undervalued and the ones lower
are Overvalued.
Estimation of Returns In CML, the expected return of the On the other hand, the return of
portfolio is demonstrated along the Y- securities is demonstrated along the
axis. Y-axis for SML
Scope 1) The market portfolio and risk- free 1) All security factors are
assets are ascertained by the CML. ascertained by SML.
2) CML ascertains the risk or return 2) SML shows the risk or return for
for proficient portfolios. each stock.
Implications of CAPM
• Markowitz model does not provide any solution to the measurement or mitigation
of systematic risk. CAPM solves this problem to a great extent. CAPM recognises
the fact that it is impossible to eliminate risk completely; however, an investor
can expect to be compensated for taking the risk that cannot mitigated through
diversification.
• CAPM provides a mean of determining the extent of systematic risk and the rate
of return that should be expected by the investors.
• CAPM considers beta to be the most significant measure of the risk of a security.
After comparing the beta with the equity risk premium, an investor can find out
the amount of compensation required in return of taking additional risk.
Implications of CAPM
Assumptions of CAPM
• Risk-free asset is always combined with market portfolio of dangerous assets by

the investors. They invest in dangerous assets according to their market value.
• Compensation will be given to the investors for the risk which could not be
diversified. It is related to market or systematic risk. Beta is the ratio of variation
between the asset return and the market returns divided by the market
variation, is considered to be most accurate measure of an asset’s risk.
• Returns can be anticipated from the investors’ investment according to the risk.
This relates to a finer connection between the asset’s anticipated return and its
beta.
Beta Stability
• CAPM considers beta to be the relevant measure of risk of a security. Beta shows
the relative volatility of a stock. The success of CAPM depends largely on the
stability of beta; stability of beta is the measure of securities` future risk. Beta is
mainly calculated on the basis of old data.
• Many studies have shown that the beta of a security does not remain stable over
a period of time. Analysts acquire old security and market portfolio data to
calculate beta.
• This indicates that the historical betas are not good indicators of securities of
future risk. CAPM is a tool for knowing the risk return connection in spite of its
restrictions. It gives a rational and quantitative attitude for calculating risk.
Let’s Sum Up
• The theory that probable return erupts with increase in risk is known as risk
return trade off. Low intensity of improbability (low-risk) is linked with less
potential returns, while high intensity of improbability (high risk) is linked with
high potential returns.
• A line that shows the systematic, or market, risk against the return of all market
at a particular time and demonstrates each risky marketable security is known
as Security Market Line (SML).
• The security market line is an effective instrument for ascertaining if an asset is

taken into consideration since portfolio gives practical expected return for risk.
Each security is marked on the SML graph.
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Chapter 7: Asset Pricing
Principles – II
Chapter Index

From-To
2 Topic 1 Arbitrage Pricing Theory (APT) 149-153
3 Topic 2 Factor Model in APT 154-157
4 Topic 3 Use of APT in Investment 158-160

Decisions

• Describe the concept of Arbitrage Pricing Theory
• Explain the factor model in APT
• Use APT in investment decisions

1. Arbitrage Pricing Theory (APT)
• Arbitrage Pricing Theory (APT) is a model used for identifying an asset, which is
priced incorrectly, i.e. either the asset is undervalued or overvalued. After
identifying such assets, investors gets the actual price of the asset and he/she can
bring the mispriced value of the asset to its actual price.
• APT model assumes that the return on an asset is affected by several factors and
the impact of these factors on the asset. These factors include macroeconomic
factors (like inflation, Gross National Product (GNP) and asset-specific factors.
The macroeconomic factors can be easily determined as they are known to
general public. Identifying the factors that influence a particular asset is crucial
for the investors as the impact of a particular factor is different on different
assets.
In APT model, an investor needs to identify:
• The factors that influence a specific stock
• The expected returns for each of the identified factors
• The sensitivity of the stock to these factors
The formula for APT model is as follows:
• Here, 𝑅𝑃𝑘 = Risk premium of the factor, 𝑟𝑓 = Risk-free rate and 𝑏𝑗𝑘 = Sensitivity
of the jth asset to factor.
• In arbitrage portfolio, the investor tries to maximise return on an asset without

any further investment on the asset and keeping the risk at same level.
Rule of One Price

• APT model is based on the rule of one price, which states that in efficient market,
security must have a single price, disregarding its origin.
• As per this rule, similar type of products should be sold on same prices. Though
this law is not always feasible to put in practice, it could only be practiced if there
is no competition, transaction cost, or trade barriers in any industry or country.
• The leading economists believe that in liquid financial markets the law of one
price can be accomplished because of the probability of arbitrage. The practical
aspect of this law is weak, thus, it is violated many times with the introduction of
funds like ADRs, corporate spin-offs and dual share class stocks.
Rule of One Price

• There is another law of one price used in arbitrage pricing theory that is slightly
different from the one explained earlier.
• This law is based on the fact that two financial instruments or portfolios should
have the same cost if they have same return and risk. This is because it takes
into consideration only one aspect of financial instruments that it is purchased to
earn an expected return while taking a certain amount of risk.
• The law of one price states that two financial instruments or portfolios having
same return and risk will be sold at the same price.
Assumptions of APT
• APT model can be expressed as a multi-factor model. This model assumes that
the investor holds a number of securities so that the unsystematic risk is
eliminated and returns from the securities can be maximised.
• In APT model, it is assumed that the markets are perfect and frictionless. In
addition, the investors have same perception about the returns on a particular
asset.
• APT model assumes that the restrictions on short-selling is nil.
• It is also assumed in APT model that if the condition of market equilibrium is

achieved, then there will be no riskless arbitrage opportunities available in the
market.
1. Factor Model in APT
• Statistical approach with the actual behaviour of stock returns and their co-
movements.
• Stocks in a country is affected by the interest rates, changes in technologies,

movements in the cost of resources (like men and materials), etc.
• APT model takes into account various macroeconomic factors that affects the
returns from a stock.
• A factor model is the one that represents a set of factors and their relationship
with the assets’ return. These factors include macroeconomic factors that affect
an asset and firm-specific or asset-specific (idiosyncratic) factors.
The factors should possess the following 3 characteristics:
– Every factor should have an impact on the stock returns.
– Factors should also affect the expected returns of the stock. This can be
determined by statistically analysing which factor pervasively impacts the
stock returns.
– At the beginning of each financial period, it is difficult to predict the risk

factors as a whole in the market.
• The main point in factor model is the deviation of the factor from the expected
value. For example, if the expected rate of inflation is 5% and the actual inflation
rate is 4%, then 1% deviation will affect the actual return from the stock.
• In APT, factor model can be expressed as follows:

𝑟෥𝑖 = 𝐸 𝑟෥𝑖 + 𝑏𝑖,1 𝑓෪ ෪ ෦
1 +. . . +𝑏𝑖,𝐾 𝑓𝐾 + 𝑒𝑖
• Here, 𝑏𝑖,𝑗 = represents increase in the asset return (i) due to one unit increase in
the factor (j), also called factor loading and 𝑒෦
𝑖 = Idiosyncratic risk
• As 𝑒෦
𝑖 is a firm-specific factor, any change in the organisation will affect it, which
further impacts the overall return on the asset.
• In APT, it is assumed that the expected value of each factor F is zero and so the
value of f ’s in the above equation is the deviation of each factor from this
expected value.
• If the expected return of portfolio A is equal to the risk-free rate as the value of
beta is equal to zero. The ratio of risk premium to beta of another portfolio B, is:
(12 − 6)/1.2 = 5, while that of portfolio E's ratio is (8 – 6)/0.6 = 3.33.
• In such a case, an arbitrage opportunity exists. For instance, a portfolio C is

created by clubbing portfolio A and B in equal proportions and taking beta of
portfolio E, i.e., 0.6. Thus, the expected return of portfolio C is: E(rG) = .5 × 12%
+ .5 × 6% = 9%
• As C and E has same same beta and return, an arbitrage opportunity exists. An
investor can earn profit by buying portfolio C and selling equal amount of
portfolio E. In such a case, the profit earned by the investor will be equal to: rG –
rE = (9% + .6 × F) – (8% + .6 × F) = 1%
1. Use of APT in Investment Decisions
• APT is an strategic approach to portfolio management.
• It helps the investors to identify the factors that affect most of the securities and
their influence on the returns of these securities. This information enables the
investor to design their portfolio in a manner that its performance is improved.
• APT model also help investors to identify the factors to which a particular sector
or industry is sensitive to and the degree of this sensitiveness.
• Utility sector is insensitive to factors like unexpected inflation and change in the
growth rate of profits. In case of industries, studies shows that retail, mobile, and
hotel industry is more sensitive to unexpected inflation while food, shoes, and tire
industry are least sensitive to it. Such information helps the investors to make
investment decisions and design their portfolio accordingly.
• A portfolio manager can also forecast the movement of the factor, which affect the
return on the asset or securities. This will further help the manager to design its
portfolio in a manner that the impact of the factor is minimum.
• For doing so, the manager can select the assets that are least sensitive to the
factor and sensitive to the factors that are favourable in the present market
situation. This will help the manager to enhance the performance of his/her
portfolio.
• APT model is often used in hedging of funds wherein the investors want to make
bets on the relative prices of financial the funds which they believe to be
inconsistent with respect to economic fundamentals without exposing themselves
to other things happening in the markets.
Example of risk arbitrage for understanding the importance of APT model in

investment decisions.
• Suppose McDonald’s new fat free burger has more demand than the new fat free
burger of Burger Kings. Based on this assumption, if an arbitrager buy $10,000
worth of McDonald’s stock and sell $10,000 of Burger King stock, then his/her
decision is impacted only by one factor, i.e. the difference between the two
companies’ firm-specific movements.
• However, the strategy adopted by the arbitrager involves considerable risk by

several other factors, such as any change in the management of the organisation,
changes in law or legal aspects related to the companies, etc. This is an example
of risky arbitrage or use of APT model in investment decisions.
Let’s Sum Up
• Arbitrage Pricing Theory (APT) is a model used for identifying an asset, which is
priced incorrectly, i.e. either the asset is undervalued or overvalued.
• APT model assumes that the return on an asset is affected by several factors and
the impact of these factors on the asset.
• APT model is based on the rule of one price, which states that in efficient market,
security must have a single price, disregarding its origin.
• A factor model is the one that represents a set of factors and their relationship
with the assets’ return. These factors include common factors (macroeconomic
factors) that affect an asset and firm-specific or asset-specific (idiosyncratic)
factors.
Post Your Query
Chapter 8: Portfolio
Analysis Techniques
Chapter Index

From-To
2 Topic 1 Fundamental Analysis 168-173
3 Topic 2 Use of Financial Statements 174-183
4 Topic 3 Forecasting Earnings per Share 184-185
5 Topic 4 Price/Earnings Ratio Analysis 186-187
6 Topic 5 Technical Analysis 188-193

Chapter Index

From-To
7 Topic 6 Difference between 194

Fundamental Analysis and
Technical Analysis
8 Topic 7 Technical Indicators 195
9 Let’s Sum Up
• Discuss the concept of portfolio
• Understand the fundamental analysis
• Explain how the financial statements can be useful
• Analyse the price/earnings ratio
• Discuss the technical analysis
• DDifferentiate between fundamental analysis and technical analysis
• Understand technical indicators

1. Fundamental Analysis
• Fundamental analysis is an analytical and methodical approach to measure the

future dividends and share price. Fundamental analysis can be categorised as the
detailed study of the basic factors like economy, industry and the like that affects
the performance of an organisation.
• The main task in fundamental analysis is to explore and interpret the financial
statements of the organisations. By analysing this, the company’s future
performance can be judged by the fundamental analysts.
• Fundamental analysis is an analysis of any entity in terms of its price movement.

The rationale behind the analysis is that the performance of an organisation not
just depends on its own efforts, but also has a great deal to do with general
industry and economic factors.
• Fundamental analysis includes three types of analysis:
Fundamental Analysis Economy Analysis
Industry Analysis
Company Analysis
The Economy Analysis

• Performance of a company is directly related to the economy’s performance of the
market/state/country in which it operates. When the economy is soaring high, the
income rises, demands for items increases, and vice versa.
• If there is a downfall in the economy, it adversely affects the performance of the

company. Such an analysis will give an idea about the forecast of corporate
earnings and payments of dividends and interest of the investors.
• The factors that affect the assets and their returns are business cycle, fiscal and,
monetary policy of the government, inflation, unemployment level, consumption
level, investment opportunities, exchange rates, etc.
The Industry Analysis

• In industry analysis, the nature of the industry, the regulatory control within the
organisation, and the phase of the industry’s development cycle are identified and
studied.
• It includes the study of the following factors:
– Demand of assets in the market
– Pricing of assets
– Costs of the asset for the organisation
– Impact of the economics and financial aspects of the market on the assets’
performance
The Industry Analysis

The Company Analysis

• The industry analysis assists the investor to choose an industry where the return
are maximum. After identifying the industry for the investment purpose, the
investor selects a company in that industry on the basis of the company analysis.
• Company analysis is conducted using the publicly disclosed and audited financial
statements of a company for a period not less than three years. These statements
include Balance Sheet, Profit/ Loss Statement, Cash Flow Statement and
Statement of Profit Distribution.
• In company analysis, the analyst tries to predict the future earnings of the
company as the company earnings have a direct and powerful effect upon the
share prices.
1. Use of Financial Statements
Financial
Statements
Income Balance Cash Flow

statement Sheet Statement
Revenue Asset Liability Equity Operation
Paid-in
Expenses Current Current Investment
Capital
Retained
Profits Non-Current Non-Current Financing
Earnings
• Financial statement is the one that shows the financial state and performance of
an organisation over a period of time.
• These statements include an operating statement (i.e. an income statement), a

balance sheet, and cash flow statement.
• Ledger account can alone define the financial statement as it is considered as a

dimension focus when you create a financial statement.
The Balance Sheet

• According to the American Institute of Certified Public Accountants, “Balance
sheet is a tabular statement of summary of balances (debits and credits) carried
forward after an actual constructive closing of books of account and kept
according to principles of accounting.”
• A balance sheet refers to a financial statement that represents the financial

position of an organisation in the market on a specified date.
• Assets are placed on the right side while liabilities on the left side of a balance
sheet. It includes assets and liabilities of the organisation. Assets are the debit
balances of the organisation while liabilities are the credit balances shown on a
balance sheet.
The Balance Sheet

Cash Flow Statement

Cash Flow Statement

• The cash flow statement contains two columns.
– The first column defines the name of each category of cash receipts and
payments. Each name describes a row in the cash flow statement. The rows
are defined by the company and do not necessarily correspond to the ledger
accounts. Here, the rows define the cash equivalents and the source over the
specific interval.
– In the second column, the rows define the total company’s cash for a specific
interval. For all the main components are debits and credits, which are
added together in the total rows.
Income Statement
Income Statement
• The income statement is categorised into operating and non-operating sections.
• The operating section of the income statement includes revenues and expenses
resulted from the regular business operations.
• The non-operating section includes revenue generated and expense incurred

during activities that are not related to regular business operations of an
organisation.
• Among these two sections, only operating section is used by investors for taking
investment decisions.
Analysing Return on Assets and Return on Equity

• Return on Assests (ROA) provides investors with an idea of how effectively an
organisation is utilising its assets to generate more income for future growth of
the organisation.
• ROA can also be defined as the ratio of annual net income to average total assets
of an organisation during a financial year. It is a measure of an organisation’s
ability to generate net income from its assets.
• Mathematically, it can be represented as follows:
• ROA = Annual Net Income/ Average Total Assets

Analysing Return on Assets And Return on Equity

• Return on Equity (ROE), also referred to as Return on Capital is the ratio of an
organisation’s net income during a financial year to its stockholders' equity
during that year.
• It is an indicator of the profitability of stockholders' investments in the

organisation. In other words, ROE shows net income as percentage of shareholder
equity. Mathematically, it can be expressed as follows:
• ROA = Annual Net Income/ Average Stockholders Equity
• ROE is a measure of an organisation’s profitability. Higher ROE ratio is generally

better as it implies that the organisation is efficient in generating income on new
investment.
1. Forecasting Earnings per Share
• The estimates of consensus earnings enables the investors to calculate the actual
value of an asset. The performance of an asset can be determined based on the
company's earning power.
• Stock analyst team is hired by the large brokerage firms like Citigroup and
Merrill Lynch to forecast company’s earnings report over the coming years.
• The average or medium of the specific stocked tracked by the analysts is termed
as consensus forecast number. If the company is small, the average is calculated
on the basis of one or two analysts forecast.
• The consensus estimates for quarterly earnings of an organisation can be

obtained for current quarter, next quarter, and so on upto eight quarters.
2. Forecasting Earnings per Share
• The investors take the investment decision based on the earning performance.
Eearning per share is used as the basic measurement of earnings. An
organisation’s earnings per share (EPS) is calculated by taking net income (less
preferred dividends) and dividing it by the number of shares of common stock
outstanding.
• EPS is a measure that allows the investor to estimate the amount of money that
remains for every share of stock issued to the public.
• Earning Per Share (EPS) = Net Income – Preferred Dividends/ No. of common
shares outstanding
1. Price/Earnings Ratio Analysis
• Price/Earnings (P/E) ratio is the one that depicts the market price per share and
the earnings per share of an organisation.
• It is used for determining the actual price of a stock in the market by forecasting
its earnings per share.
• Companies having higher future earnings are expected to pay high dividends.
• P/E ratio helps the investors to identify the actual price at which they should
purchase a stock. This is determined based on the current earnings from the
stock. The formula for calculating P/E ratio is as follows:
• P/E Ratio = Market Share Price / Earnings Per Share
• The market price of the share is obtained fron secondary markets such as NSE
and BSE.
2. Price/Earnings Ratio Analysis
• An organisation with a high P/E ratio generally indicates positive future

performance. Investors are willing to pay more for a company's shares with a
higher P/E ratio. This means that the P/E ratio of the company is high, which
shows that organisation’s performance is good. As a result, investors wants to
invest in such a company.
• However, if the P/E ratio is low, it will show that the company’s performance is
not good and thus, investors will resist from investing in the company.
• As P/E ratio is calculated by dividing the company’s stock price per share with its
EPS, it gives the investors an idea of whether a stock is undervalued or
overvalued.
• PE ratio can mislead the investors. If it is based on past data or estimates; there
is no guarantee that earnings will remain the same or will be accurate.
1. Technical Analysis
• In addition to fundamental analysis, technical analysis is also used for analysing

securities and taking decisions based on this analysis.
• One of the basic differences between fundamental analysis and technical analysis
is that the former involves the analysis of the characteristics of a company for
estimating its value while the latter involve the determination of price
movements of the stock in the market.
• Technical analysis refers to a method of analysing the securities of an

organisation by assessing the data generated in the market. Technical analysis is
based on past prices and volume of securities.
• Technical analysts depend on charts and other tools for determining the patterns
of behaviour of a security in order to predict its future movement.
Stock Price And Stock Volume

• A share price refers to the price of a single share in a number of saleable stocks of
a company.
• In simple words, stock volume means the number of shares traded in a security
or in the entire market at a particular period. Therefore, stock volume refers to
the amount of stocks that are traded.
• Stock volume is a measure of activity in the stock market. Information regarding

stock volume is easily available in the market.
• It requires expertise to effectively use stock volume to increase profits and

minimise risks.
Line Chart: In a line chart, the closing price of stocks for a period of time is plotted.
Next, the closing prices are connected to form the line. The line chart uses the closing
price of stocks as the closing price is considered to be the most significant data in
stock prices in comparison with the intra-day high and low data.
Bar Charts: A bar chart is prepared by including few more information in the line
chart. A bar chart consists of a set of verticle lines representing the data points. The
vertical lines in the graph shows the intra-day high and low along with the closing
price.
Candle Stick Chart: There is significant similarity between a bar chart and a
candlestick chart. The only difference is in the visual constructions of the charts. In
the candle stick chart, a thin line shows the trading range of a period.
Dow Theory
• The theory is based on stock price trends in the market. It has been empirically
seen that the market tends to move in a general direction or trend.
• The theory proposes that the overall market trend is determined by three types of
trends: primary trends, secondary trends, and minor trends.
• The primary trend is the long term secular trend that last for a period greater
than 12 months. The secondary trend involves movement against the primary
trend. It is an intermediate trend and it is observed for a period ranging from
three weeks to three months. Lastly, the minor trend lasts for the shortest period
of time (generally, less than three weeks).
Difference between Fundamental Analysis and Technical
Analysis
Fundamental Analysis Technical Analysis
It analyses securities by measuring the It analyses securities by studying

intrinsic value of a stock. statistics produced by market activities.
It takes into account the prospect of the It takes into account the statistical
company, general market conditions, and information of previous price movements
the prospect of the industry to determine of stocks of a company to find a pattern
the intrinsic value of a stock. in past price movements and predict
future stock price.
It focus on the analysis of overall It focuses on the analysis of the trend of
financial performance of a company to past stock prices rather than the
predict stock prices in the future financial condition of a company.
It is a long-term approach It is done for short-time.
Technical Indicators
Breadth Indicators: A breadth indicator refers to the mathematic formula that helps
in calculating the market participation. Breadth indicators evaluate the volume of
stocks going up and down and the amount of trades placed by the investors to
determine whether the overall market is bullish or bearish.
Sentiment Indicators: A sentiment indicator refers to a graphical or numerical

indicator that shows what perception a group of investors have in the market or the
overall business environment. In other words, sentiment indicator takes into account
various factors, such as inflation rate, political stability, GDP, economic condition,
etc. to influence the future behaviour of the investors.
Let’s Sum Up
• Fundamental analysis is an analytical and methodical approach to measure the

future dividends and share price.
• Financial statement is the one that depicts the financial state of company at the
end of a specified period. It can be an income statement, a balance sheet or other
financial information.
• In order to get maximum return, investors forecast the future earnings of an

organisation so that they can take the decision to whether invest or not in an
organisation.
• Technical analysis refers to a method of analysing securities of an organisation by

assessing its statistics generated by market activity.
• Fundamental analysis and technical analysis are used for analysing and
predicting the future trends of stocks.
Post Your Query
Chapter 9: Efficient
Market Theory
Chapter Index

From-To
2 Topic 1 Concept of Efficient Market 202-203
3 Topic 2 Evidence on Efficient Market 204-205

Theory
4 Topic 3 Tests for Market Efficiency 206-213
5 Topic 4 Market Anomalies 214-219
Let’s Sum Up 220

• Discuss the concept of efficient market
• Describe evidences on efficient market theory
• Identify various tests for market efficiency
• Explain concepts related to market anomalies

1. Concept of Efficient Market
• According to Louis Bachelier, a French mathematician, “an efficient market is

the one where the market price is an unbiased estimate of the true value of the
investment.”
• All markets are not efficient for all investors but a market can be efficient for an
average investor.
• The following points must be kept in mind in the context of efficient markets:
– In an efficient market, it is not necessary that the market price of an asset is

always equal to its actual value. However, the changes in the asset price
should be valid and unbiased. In other words, the deviation of market price
from the true value of an asset should be random.
2. Concept of Efficient Market
– In case the deviations in the prices of assets from its true value are random,
the prices can be either undervalued or overvalued anytime. These and
deviations are also not correlated with any observable variable. For example,
the prices of an asset having low P/E ratio is not undervalued than the prices
of assets with high P/E ratio.
– In an efficient market, investors are unable to find either undervalued or

overvalued assets to which the rest of the market is unfamiliar using any of
the investment strategies.
1. Evidence on Efficient Market Theory
Evidences on efficient market theory are classified into the following four sections:
1. Study related to price changes and their time series properties: These studies on
market efficiency emphasised the relationship between the time and the change
in the asset price. Tests were conducted using random walk theory of price
movements, which states that the price of assets changes with time on a random
basis. This is an evidence of efficient market.
2. Return anomalies across firms and over time: Anomalies shows the inefficiency of
the market in the underlying asset-pricing model. When these anomalies are
identified and analysed in academic literature, it is found that the anomalies are
either disappeared or reversed. This is because of the difference in the time
period of sample collection.
2. Evidence on Efficient Market Theory
3. Research related to the efficiency of market reaction to information

announcements: New information related to different assets comes to market on a
regular basis. So, the reaction of investors on such information is instantaneous and
unbiased. Researches show that reaction of markets to the announcements of an
innovative investment is different from that of a non-innovative investment. Thus,
the price of assets or stocks of an innovative investment is more than the non-
innovative investments as soon as it enters the market.
4. Analysis of the performance of analysts, money managers and insiders: These

analysis shows that it is not necessary that the insiders, analysts, and portfolio
managers are able to perform better than the average investors and earn more
money.
1. Tests for Market Efficiency
Different Types Of Tests Used For Judging Efficiency Of A Market:
Random Walk Tests
Weak form Tests
Semi-Strong Form Tests
Strong Form Tests

Random Walk Test

• Random Walk Theory was first proposed by French broker and Jules Regnault in
1863. Later, some of the points have been added in this theory by Louis Bachelier
in 1900.
• The Random Walk Theory states that the change in the market price of the stock
is random and thus, cannot be predicted. The changes in stock price are evenly
distributed and are independent of each other.
• As per this theory, the past trend of stock price or market will not affect its
movement in the future.
• Technical analysis relies exclusively on past trading data to forecast future price
movements.
Random Walk Test

• As a test for market efficiency, Random Walk Theory depicts that the change in
prices of stock will take a random and unpredictable path.
• It also states that an investor cannot outperform the market if the additional
risks are not taken into consideration.
• The critics of this theory say that stocks maintain certain price trends over a
period of time. So, an investor can outperform the market by choosing the right
times to enter into and exit from the market.
Weak Form Tests

• According to weak-tests, a market is said to be efficient if it reflects all
information available in the market at a given point of time.
• This theory assumes that the rates of returns in the market do not depend on any
factor and there is no impact of past rate of market return on its future rates.
Weak Form Tests

• The weak form tests can be of the following types:
– Statistical tests for independence: These tests are further classified as auto
correlated tests and runs tests. They check whether the rate of return from
market is significantly correlated over a period of time. On the other hand, in
runs tests, it is tested whether the change in stock price is independent of
time.
– Trading tests: These tests are conducted to confirm that the past returns do
not help in predicting the future rate of returns from a market.

• The semi-strong form tests show that the market reflects all the publicly
available information related to the different stocks and their prices in the
market.
• Warren Buffet, whose portfolio has for the past consistently outperformed the
market portfolio, supports the semi-strong form tests which states that an
investor cannot earn above the market return using historical data.

• The semi-strong form tests are of the following types:
– Event Tests: This test analyses a stock before and after the announcement of
an event like earnings or merger of an organisation. As per this test, an
investor cannot earn an above average return by purchasing or selling assets
based on the information of an event.
– Regression/Time Series Tests: This test helps in forecasting future returns

from the market based on the historical data. Thus, an investor cannot earn
an above average return by applying this method.
Strong Form Tests

• Strong-form tests show that the market is efficient if it is able to reflect all
information related to public or private sector securities.
• This test depends only on a group of investors who have the maximum
information about the securities in the market.
• These investors are:
– Insiders
– Exchange Specialists
– Analysts
– Institutional money managers

1. Market Anomalies
• An anomaly refers to the occurrence of an unusual event.
• In the language of finance and investing, anomalies refer to the instances in

which a particular security or a portfolio shows opposite performance to the
beliefs of the efficient market theory.
• In an efficient market, anomalies should not occur and these should not definitely
persist. There is no unanimous conclusion on why anomalies take place. There
are many opinions regarding the occurrence of anomalies. Many market
anomalies take place once and then they disappear. On the other hand, there are
anomalies that are continuously observed. Investment professionals study these
recurring anomalies to find a pattern and exploit them while investing.
2. Market Anomalies
Earnings Announcement
• Companies periodically announce their earnings reports and other corporate
reports that are important to the stakeholders. Earning announcements are
made on certain dates.
• The earning announcements cause various market anomalies. They are:
– Stock Split Effect
– Short-term Price Drift
– Merger Arbitrage
3. Market Anomalies
Price/Earnings Ratio
• Price/earnings ratio refers to the ratio of price of a stock and its earnings.
• It has been observed that portfolios consisting of low P/E securities perform
better than the portfolios consisting of high P/E securities.
• Low P/E stocks presumably involve greater risks; therefore, they have more
potential to give better return.
• P/E ratio can be calculated as P/E Ratio = Current Share Price/ Earnings Per
Share
4. Market Anomalies
Firm Size Effect

• Empirical studies have shown that small-sized firms or the firms with low
market capitalisation, outperforms large companies.
• The theory that smaller companies possess higher growth potential than larger
companies give rise to various market anomalies.
• An organisation’s economic growth forms the driving force behind its stock's
performance. Smaller firms tend to have more capacity for growth compared to
the larger companies, which have already reached the saturation price levels.
• Smaller firms are often able to grow much faster than larger companies, which
are reflected in their stock prices.
5. Market Anomalies
January Effect
• Stock prices have a general tendency to go up in the month of January. Generally,
this appreciation in the stock prices happens because of an increase in buying
followed by a drop in stock prices in the month of December.
• It has been observed that small caps are more affected by the January effect than
the mid or large caps.
• Due to the tax-selling pressure of companies, large number of stocks becomes

available at attractive prices for buyers in January. Investors too wait until
January to buy underperforming stocks.
• The excess selling in the year end and excess buying of stocks after January 1
lead to January effect
6. Market Anomalies
Monday Effect
• This effect is also known as “Weekend Effect”.
• It has been seen that there is a general tendency of the stock prices to go down
on Mondays.
• Investment experts have observed that returns in the market on Mondays is

mostly lower than returns on other days of the week.
Let’s Sum Up
• Tests for market efficiency are carried out to determine whether specific
investment strategies helps investors to earn more returns on assets in the
market or reduce transactions costs or provide execution feasibility.
• Random Walk Theory states that the change in the market price of the stock is
random; and thus, cannot be predicted.
• According to weak-tests, a market is said to be efficient if it reflects all

information of the market. The semi-strong form test shows that the market
reflects all the publicly available information related to the different stocks and
their prices in the market.
• Strong-form tests show that the market is efficient if it is able to reflect all
information related to public or private sector securities.
Post Your Query
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relating to this course presentation please login to Student Zone.
Chapter 10:
Evaluation of
Portfolio Performance
Chapter Index

From-To
2 Topic 1 Determinants of Portfolio 226-228

Performance
3 Topic 2 Methods of Calculating Portfolio 229-237

Returns
4 Topic 3 Risk-Adjusted Performance 238-241

Measures
5 Topic 4 Relative Risk of Mutual Funds 242-243

 Explain the determinants of portfolio performance
 List the methods of calculating portfolio returns
 Discuss risk-adjusted performance measures
 State the relative risk level of mutual funds

1. Determinants of Portfolio Performance
Asset Allocation
Determinants of Portfolio
Performance
Market Cycles Risk and Returns

• The rate of return of a portfolio is measured as the sum of cash received (dividend) and
the change in the portfolio’s market value (capital gain or loss) divided by the market
value of the portfolio when it was purchased.
• Mathematically, it can be expressed as follows:
(Cash Dividend + Capital (gain or loss) (Cash Dividend + Capital (gain or loss)
Return of a portfolio =
Market value of portfolio (purchase price) Market value of portfolio (purchase price)
• There are three main determinants of portfolio performance:
1. Asset Allocation: It is the major determinant of the long-term performance of a portfolio's

long-term return. Asset allocation is all about classifying an investment portfolio into three
asset categories: stocks, bonds, and cash. The asset allocation that is the most appropriate
for an organisation at a particular point in time depends on the time horizon and its ability
for risk tolerance.
2. Risk and Returns: Every investment of an organisation is subject to a certain

degree of risk. Higher the risks associated with an investment, higher the chances
are for good investment returns.
3. Market Cycles: These refer to trends or patterns in a given market environment,

allowing some securities or asset classes to outperform others. Every asset category
has a unique cycle. Revenue and net profits may exhibit similar growth patterns
among many companies within the same sector or industry.
1. Methods of Calculating Portfolio Returns
Commonly used methods for estimating returns on investment:
Money
Weighted
Rate of
Return
True Time Linked

Weighted Methods of Internal
Rate of Calculating Rate Rate of
Return of Return Return
Modified
Dietz
Return
• Effective asset allocation is not only sufficient for an organisation to achieve its
financial goals. An organisation needs to measure the performance of its portfolio
within the decided time horizon.
• The performance of portfolio is measured in two ways: one is to calculate returns

on investment and the other is to estimate risk content of the investment.
Organisations use different methods for calculating returns on investment. These
methods are described in the following slides.
Money Weighted Rate Of Return

• An assessment of the profit rate for an asset or portfolio of assets is called money
weighted rate of return.
• It can be estimated by calculating the rate of return that will fix the current
values of all cash flows and terminal values same as the value of the first
investment.
• The money weighted rate of return is same as the internal rate of return (IRR)
because it ascertains that the similar rate of return is achieved during every sub-
period of the possibility of an investment.
• Money weighted rate of return is the discount rate at which the NPV=0 or the
rate at which the PV of inflows is equal to the PV of outflows.
Money Weighted Rate Of Return

• Cash outflows:
– The cost of any investment purchased
– Reinvested dividends or interest
– Withdrawals
• Cash inflows:
– The proceeds from any investment sold
– Dividends or interest received
– Contributions
Linked Internal Rate Of Return

• The Linked Internal Rate of Return (LIRR) is used to estimate the accurate time
weighted rate of return (TWRR).
• In this method, the internal rate of return is calculated over consistent time
periods, and the outcome is associated geometrically.
• The following formula can be used to calculate LIRR:
LIRR= (1+R1) × (1+R2) × (1+R3) ×….. (1+Rn) - 1
Where, R is the internal rate of return at different time periods

Linked Internal Rate Of Return

• If the consistent time intervals are not years, the un-annualised investment time
adaptation of IRR for each period or the IRR for every time period should be
estimated.
• After that, each IRR should be converted into the investment period return over
the time period and investment period profits should be connected to get the
LIRR.
Modified Dietz Return

• The Modified Dietz return is a simple interest estimate of Money Weighted
Returns.
• The Modified Dietz method provides a computational advantage over the IRR
method as it is a closed form solution and does not require several trial and error
exercises before arriving at the final figure.
• The calculation takes into account the cash flows that have been adjusted to
reflect the time they were available for investment in the portfolio.
Modified Dietz Return
• Modified Dietz return =
• Wi =>
True Time Weighted Rate Of Return

• The true time weighted return method is used to measure portfolio return
indifferent towards cash inflow and outflow of the portfolio.
• Unlike the Dietz or internal rate of return, the true time weighted return does
not use money weighted estimations.
• In place of money weighted estimations, the true time weighted return method
estimates the return of the portfolio as time weighted average of its component’s
return (in spite of cash add-ons and extractions to the portfolio).
1. Risk-Adjusted Performance Measures
• Risk-adjusted performance measures are the metrics that analyse the return on
investment with a few alterations for the threat.
• It could be income, gains, returns, and so on. In the same way, volatility, beta,
value at risk are some of the ways in which the threat can be estimated.
• In the 1960s, some were created for examining the competency of the market
theory, which are now used by practitioners for asset allotment and presentation
evaluation. They are Treynor ration, Sharpe ratio and Jensen’s alpha.
• Return on Capital (ROC) and Risk-adjusted Return on Capital (RAROC) are

other risk-adjusted performance measures created in the 1980s and 1990s to back
financial capital allowance.
Sharpe Ratio
• The Sharpe ratio or the reward to variability ratio ascertains the performance of
an investment by regulating the risk.
• The ratio estimates the excess return or risk premium for each unit of deviation
in the investment asset or trading strategy, classically referred to as risk.
• Sharpe ratio =>
• To compute the Sharpe ratio, one must know three things, the portfolio return,
and the risk free rate of return and the standard deviation of the portfolio. The
Sharpe index is computed by dividing the risk premium of the portfolio by its
standard deviation or total risk.
Treynor’s Reward To Volatility

• The Treynor ratio is a method used to estimate how well a portfolio has
compensated its investors at the given risk level. This method relies on beta,
which is the sensitivity of an investment to market fluctuations, in order measure
associated risk content.
• The Treynor’s ratio is useful for assessing the excess return, helps investors to
evaluate how the portfolio structure to different levels of systematic risk that
would affect the return.
• Treynor Index (Tp) =>
• Treynor’s index is achieved, which implies a better portfolio investors regardless

of risk profiles.
Jensen’s Alpha
• Jensen’s alpha is used to ascertain the irregular return of a security or portfolio
of securities over the hypothetical anticipated return. The method is based on the
perception that assets that are more vulnerable have more anticipated returns as
compared to less vulnerable ones.
• Jensen index utilises the security market line as a benchmark. An important

point to consider while using the Jensen’s index is the choice of the market index
as the portfolio performance is compared to the market portfolio.
• Jensen’s alpha (αp) =>
• To calculate Jensen’s alpha, one needs to first calculate the CAPM return.
• CAPM Return = Rf + β(Rmkt - Rf)

1. Relative Risk of Mutual Funds
• Mutual funds are basically a collection of stocks, bonds, and other financial
assets. These funds are owned by a number of investors and managed by an
investment management organisation. An investor in a mutual fund owns a share
of the fund that is equal to the amount of his/her investment divided by the total
value of the fund.
• Benefits of mutual funds:
– Risk is shared among various securities.
– Investors need to pay high transaction costs while purchasing individual

securities. Mutual funds provide the benefit of economies of scale to investors
2. Relative Risk of Mutual Funds
Mutual Funds Vs. Benchmark Indexes

• When an investment is made in the mutual fund, risks are shared by a group of
investors. Individual stocks at times can be nullified, but if the mutual fund holds
50 stocks, it is improbable that all 50 of these stocks would become valueless.
• Market benchmarks are used for determining how a particular market performs.
Market indexes offer market standards that help in the evaluation of risk and
return history of their investments.
• In India, BSE Sensex and Nifty are most widely used benchmarks for large-cap
funds. Other benchmarks include CNX Midcap, CNX Smallcap, CNX IT, CNX
500, BSE 200, BSE 100, etc. The performance of a mutual fund vis-a-vis the
market benchmark is measured as Beta.
Let’s Sum Up
• The first step in portfolio research is to identify the determinants of portfolio

performance.
• The performance of portfolio is measured in two ways: one is to calculate returns

on investment and the other is to estimate risk content of the investment.
• Organisations use different methods for calculating returns on investment, such

as money weighted rate of return, linked internal rate of return, modified Dietz
return, and true time weighted rate of return.
• Risk-adjusted performance measures are the metrics that analyse the return on
investment with a few alterations for the threat. Some of the methods of risk-
adjusted performance measures are Sharpe ratio, Treynor ratio, and Jensen’s
alpha.
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Capital Market and

5 Chapter 5 Modern Portfolio Theory 102-125

6 Chapter 6 Asset Pricing Principles - I 126-145

8 Chapter 8 Portfolio Analysis Techniques 164-198

10 Chapter 10 Evaluation of Portfolio 223-246

• For both an individual investor and an organisational investor, it is imperative to

• Investors like to hold their portfolios at an optimum level.

S. No Reference No Particulars Slide

2 Topic 1 Introduction to Investment 8-10

3 Topic 2 Introduction to Financial 11-14

4 Topic 3 Marketable Financial 15

5 Topic 4 Nonmarketable Financial 16-17

6 Topic 5 Money Market and Capital 18-19

S. No Reference No Particulars Slide

7 Topic 6 Stock and Bond Market Indexes 20-21

8 Topic 7 Investing in Financial Assets 22

9 Topic 8 Trading Mechanics 23-25

• Describe the various types of financial instruments

• Explain the marketable financial instruments

• Discuss the non-marketable financial instruments

• Describe what money market and capital market are

• Explain stock and bond market indices

• Discuss the concept of investing in financial assets

• Explain the trading mechanics

• Making an investment requires an individual or organisation to choose from

Factors Affecting Investment Decision

• Education about investment: An investor must be educated or must have some

• Risk tolerance of the investor: It is important to understand the amount of the

Money as a Medium of Exchange

• Money has three properties that make it desirable to use it as a medium of

Stocks and Bonds

• Debt market is basically a wholesale market wherein the trading of securities

• Debt market is basically a wholesale market wherein the trading of securities

• Marketable securities can be classified into two groups:

– Marketable equity securities: These include shares of common stock and

– Marketable debt securities: These include government bonds and corporate

• Non-marketable financial instruments are the instruments, which are very

• It is difficult to find a potential buyer for non-marketable securities.

Different types of Nonmarketable securities:

• Savings account: They are a form of non-marketable securities that earn an

The main functions of money market are:

• Some of the stock market indices are as follows:

- Dow Jones Industrial Average:

- The S&P 500 Index:

- The National Association of Securities Dealers Automated Quotations

• Bond index is computed on the basis of bonds selected according to certain

• Some of the bond indices are discussed as follows:

- Barclays Capital Aggregate Bond Index:

- Salomon Broad Investment Grade (BIG) Index

- Merrill Lynch Domestic Master

- JPMorgan Emerging Market Bond Index (EMBI)

• Investing in financial assets requires careful consideration of the following

Market Nature of Impact of

• Trading mechanics involves the following steps:

• Trading mechanism of some securities and assets.

• Equity trading: It refers to the purchase and sell of an organisation’s stock

• Derivative trading: It involves the trading of various derivatives like spot,

• A financial instrument is a tradable asset of any kind. Financial instruments are

• Money acts as is a medium of exchange in the process of investment. It is through

S. No Reference No Particulars Slide

2 Topic 1 Concept of Probability 33-35

3 Topic 2 Return on Investments 36-39

E (P) = w1r1 + w2r2