Course: Capital Market & Portfolio Management

Internal Assignment Applicable for December 2023 Examination

Ans 1:

Return on common stocks or equity (ROE) refers to the profit generated by an organization with the
money invested by the common shareholders. Its calculated as follows:

ROE = (Net Income - Preferred Dividends) / (Total Shareholders' Equity)

First, you need to calculate the Total Shareholders' Equity. Total Shareholders' Equity is the
difference between the total assets and total liabilities. Since you have not provided information
about total assets and total liabilities, I'll assume that Total Shareholders' Equity is equal to the sum
of common equity and preferred stock.

Total Shareholders' Equity = Common Equity + Preferred Stock

Total Shareholders' Equity = (3,00,000 - 30,000) + 5,00,000

Total Shareholders' Equity = 2,70,000 + 5,00,000

Total Shareholders' Equity = 7,70,000

Now, you can calculate ROE:

ROE = (Net Income - Preferred Dividends) / Total Shareholders' Equity

ROE = (3,00,000 - 30,000) / 7,70,000

ROE = 2,70,000 / 7,70,000

ROE ≈ 0.3506, or 35.06%

The Return on Equity (ROE) of the organization is approximately 35.06%.

ROE depicts how much net income is earned by an organisation from the capital invested by the
common shareholders. So, ROE is considered as a measure of profitability from the perspective of
common shareholders, who are regarded as the real owner of an organization. A high ROE shows
that the profitability of the organization in high. In addition, it also represents the strong financial
position of an organization in the market.
Ans 2:

Introduction :
A Financial instrument is a tradable asset of kind. Financial instruments are key components of the
modern financial market system as they allow an efficient flow of capital through the global financial
market place. Financial instruments have some monetary value attached to them thus can be traded
for other financial instruments or can be redeemed for cash. Other financial instruments include
share certificated, bond certificates, debt, equity, treasury bills.. etc

Derivatives:
Derivatives are financial instruments whose value is derived from the value of one or more variables,
called bases (underlying asset, index, or reference rate), in a predetermined manner. They
underlying asset could include equity, forex, commodity, etc. They are commonly used for hedging,
speculation, and arbitrage.

There are several types of derivatives, including:

Futures:
Futures contracts are agreements to buy or sell an asset at a predetermined price and date in the
future. They are standardized and traded on exchanges. Futures can be used to speculate on price
movements or hedge against potential losses.

Options:
Options give the holder the right, but not the obligation, to buy (call option) or sell (put option) an
asset at a predetermined price within a specified period. Options provide flexibility and can be used
for hedging or speculative purposes.

Swaps:
Swaps involve the exchange of cash flows between two parties based on predetermined terms.
Common types of swaps include interest rate swaps, currency swaps, and commodity swaps. Swaps
are used to manage risks, such as interest rate or currency fluctuations.

Forwards:
Forwards are similar to futures contracts but are customized agreements between two parties. They
are not traded on exchanges and have more flexibility in terms of contract size and expiration date.
Forwards are commonly used in over-the-counter (OTC) markets.

Contracts for Difference (CFDs):

CFDs are derivative products that allow traders to speculate on the price movements of various
financial instruments without owning the underlying asset. CFDs offer leverage and can be used for
short-term trading strategies.

Structured Products:
Structured products are derivatives that combine multiple financial instruments to create a
customized investment. They often have embedded options or swaps and are designed to meet
specific investment objectives.
In derivative markets, there are three types of participants:

Hedgers:
They are the individuals or organisations that predict risks in the future and use derivative
instruments for reducing this risks.

Speculators:
These are the individuals or organisations that want to earn money from the fluctuations the occur
in the financial markets.

Arbitrageurs:
These are the individuals or organisations that earn money by taking advantage of dissimilarity in the
prices of assets and securities in different markets.

Although both speculators and arbitrageurs want to earn money from the loopholes or fluctuations
in the market, there is a difference in the approach of the two. Arbitrageurs of study the different
markets and their behaviour and then decide to invest in some markets. On the other hand,
speculators do not analyse the market and invest in it on the bases of general market trends and tips
circulating in the market.

It's important to note that derivatives can be complex and involve risks. It is advisable for your
colleague to thoroughly understand the characteristics, risks, and potential rewards of each type of
derivative before investing. Consulting with a financial advisor or conducting thorough research is
recommended.
Ans 3a:

Measuring Risk
There is a subtle difference between risk and return. The expected return of a portfolio is the
weighted average of the individual returns. However, in the case of risk, the expected risk of the
portfolio 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. Generally, 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 extremely risky assets in some fixed proportion.

There are three indicators of investment risks apart from variance and standard deviation that are
used to predict the volatility and return of a portfolio:
1 .Beta
2. Alpha
3. Sharpe Ratio

Sharpe Ratio:
This is a complex measurement that utilizes the standard deviation of a portfolio or stock to
measure volatility. The greater is the Sharpe ratio, the greater 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

Allocate more to the stocks with higher Sharpe ratios. In this case:

- S3 gets the highest allocation at 41.67%.

- S2 receives 33.33%.

- S1 gets the lowest allocation at 25%.

Explanation:

To prepare an optimal portfolio using the Sharpe ratio, you need to consider the risk and return of
each stock. The Sharpe ratio measures the excess return (return above the risk-free rate) per unit of
risk (standard deviation of return). The higher the Sharpe ratio, the better the risk-adjusted return.

Here's how you can calculate the weights for each stock in the portfolio:

1. Calculate the weight for each stock based on its Sharpe ratio:

- Weight for S1 = Sharpe Ratio of S1 / Total Sharpe Ratio = 1.5 / 6 = 0.25

- Weight for S2 = Sharpe Ratio of S2 / Total Sharpe Ratio = 2 / 6 = 0.3333

- Weight for S3 = Sharpe Ratio of S3 / Total Sharpe Ratio = 2.5 / 6 = 0.4167

2. Your friend can allocate their investment accordingly based on these weights. For example, if your
friend has a total investment of $100,000:

- Invest Rs.25,000 in S1 (0.25 * Rs.100,000)

- Invest Rs.33,333 in S2 (0.3333 * Rs.100,000)

- Invest Rs.41,667 in S3 (0.4167 * Rs.100,000)

This allocation should help optimize the portfolio based on the Sharpe ratios, maximizing the risk-
adjusted return.
Ans 3b:

The calculation you've provided outlines the expected return from both mutual funds and shares in a
financial investment portfolio. Let's break down the components and delve into a more detailed
explanation.

Investors often diversify their portfolios to mitigate risk and optimize returns. In this scenario, there
are two main components contributing to the total expected return: mutual funds and shares.

Expected Return from Mutual Funds:

The expected return from mutual funds is calculated using the formula:

Expected return from Mutual Fund = Investment in Mutual Fund × Expected return rate

In this example, the investment in mutual funds is not explicitly stated, but the expected return is
given as Rs. 320. Assuming a hypothetical investment of Y rupees in mutual funds, the expected
return from mutual funds can be represented as:

Expected return from Mutual Fund= Y × Expected return rate for Mutual Fund

For the this example, this is given as Rs. 320.

Expected Return from Shares:

Similarly, the expected return from shares is calculated using the formula:
Expected return from Shares=Investment in Shares × Expected return rate for Shares

In this case, the investment in shares is Rs. 10,000, and the expected return rate is 12%. The
calculation is as follows:

Expected return from Shares= 0.60 × Rs.10,000 × 0.12 = Rs.720

Here, 0.60 represents 60%, as mentioned in the calculation.

Total Expected Return:

The total expected return is the sum of the expected returns from both mutual funds and shares:

Total expected return=Expected return from Mutual Fund+Expected return from Shares

Substituting the given values:

Total expected return = Rs.320 + Rs.720 = Rs.1,040

Therefore, the overall expected return from the investment portfolio, combining mutual funds and
shares, is Rs. 1,040.

Importance of Diversification:
Diversification, as evidenced in this scenario through investment in both mutual funds and shares, is
a key strategy in managing investment risk. Mutual funds offer a diversified portfolio of assets
managed by professionals, spreading risk across various instruments. On the other hand, shares, or
equities, have the potential for higher returns but come with higher volatility.

By combining these two types of investments, investors aim to achieve a balance between stability
and growth. Mutual funds provide a steady, albeit moderate, return, while shares offer the
possibility of higher returns but with a higher level of risk.

Conclusion:
In the world of finance, understanding expected returns is crucial for investors to make informed
decisions. This calculation illustrates how the expected return from mutual funds and shares
contributes to the overall anticipated gain in a diversified investment portfolio. The careful balancing
of risk and return through diversification is a fundamental principle in financial management, helping
investors navigate the complex landscape of the market.