Investment Analysis and

Management
Arun G Dsouza
Assistant Professor
JKSHIM Nitte
Course Overview
• The course is designed to introduce the students to investment analysis and
management including portfolio theories, asset classes, asset pricing, investment
strategies and tracking the performance of the portfolio.
• The course begins by understanding the importance of investment objectives in
portfolio management and exploring the various asset classes for investment.
• The course then proceeds to the portfolio theories, risk return analysis and asset
valuation tools which is necessary for asset allocation.
• The final part of the course imparts the techniques for evaluating the
performance of the portfolio.
Learning Outcomes
The expected learning outcomes from this course are listed below:
• To be able to apply the portfolio theories in investment decision making.
• To be able to evaluate asset classes for investment.
• To construct a portfolio to achieve the investment objective.
• To be able to track the performance of the portfolio against the benchmark.
Reference Materials
• Chandra, Prasanna, Investment Analysis and Portfolio Management, 8th Edition Tata McGraw-Hill Publishing
Company, 2017.

• Bodie, Zvi, Kane, Alex and Marcus, Alan (2019), Essentials of Investments, (11th Edition), McGraw Hill
Education.
Evaluation Tools
**Internal Assessment (written) Test I 10 marks

**Internal Assessment (written) Test II 10 marks

Quiz & Assignments 10 marks

Investment Challenge 10 marks

Class Participation 10 marks

Semester-End-Exam 50 marks

Total 100 marks

Background to Portfolio Management
• Why do we need to learn Portfolio Management?
• Obviously to make money….
"I can calculate the motions of heavenly bodies, but not the
madness of people."
- Isaac Newton after losing $2.72 Million in the Stock Market.
What’s so special
about this
gentlemen……
 What’s so
special about
this
gentlemen……
Three stages in making money…..
1. You make money…..
Salary (5% Salary (5% Salary (5%
Year Year Year
Growth) Growth) Growth)
0 5,00,000 12 8,97,928 24 16,12,550
1 5,25,000 13 9,42,825 25 16,93,177
2 5,51,250 14 9,89,966 26 17,77,836
3 5,78,813 15 10,39,464 27 18,66,728
4 6,07,753 16 10,91,437 28 19,60,065
5 6,38,141 17 11,46,009 29 20,58,068
6 6,70,048 18 12,03,310 30 21,60,971
7 7,03,550 19 12,63,475 31 22,69,020
8 7,38,728 20 13,26,649 32 23,82,471
9 7,75,664 21 13,92,981 33 25,01,594
10 8,14,447 22 14,62,630 34 26,26,674
11 8,55,170 23 15,35,762 35 27,58,008
Total Money Earned 4,79,18,161
Three stages in making money…..
2. You make money and money makes money……
Value of Rs. 1,00,000 invested today after n Years
Return
5 10
5.00% 1,27,628 1,62,889
7.00% 1,40,255 1,96,715
10.00% 1,61,051 1,61,051
12.00% 1,76,234 3,10,585
15.00% 2,01,136 4,04,556
20.00% 2,48,832 6,19,174
Three stages in making money…..
3. You make money, money makes money and lots and lots of money
makes lots and lots of money….
Value of Rs. 1,00,000 invested today after n Years
Return
15 20 25 30 35
5.00% 2,07,893 2,65,330 3,38,635 4,32,194 5,51,602
7.00% 2,75,903 3,86,968 5,42,743 7,61,226 10,67,658
10.00% 4,17,725 6,72,750 10,83,471 17,44,940 28,10,244
12.00% 5,47,357 9,64,629 17,00,006 29,95,992 52,79,962
13.00% 6,25,427 11,52,309 21,23,054 39,11,590 72,06,851
14.00% 7,13,794 13,74,349 26,46,192 50,95,016 98,10,018
15.00% 8,13,706 16,36,654 32,91,895 66,21,177 1,33,17,552
16.00% 9,26,552 19,46,076 40,87,424 85,84,988 1,80,31,407
17.00% 10,53,872 23,10,560 50,65,783 1,11,06,465 2,43,50,347
18.00% 11,97,375 27,39,303 62,66,863 1,43,37,064 3,27,99,729
19.00% 13,58,953 32,42,942 77,38,807 1,84,67,531 4,40,70,061
20.00% 15,40,702 38,33,760 95,39,622 2,37,37,631 5,90,66,823
So what is investment
• An investment is an asset that is purchased with the hope that it
will generate income or will appreciate in the future.
• In an economic sense, an investment is the purchase of goods
that are not consumed today but are used in the future to create
wealth.
• In finance, an investment is a monetary asset purchased with the
idea that the asset will provide income in the future or will be
sold at a higher price for a profit.
Financial Markets and the Economy
• Consumption Timing
• Use securities to store wealth

• Transfer consumption to the future

Dollars

Consumption

Savings
Dissavings
Dissavings
Income

Age
Three considerations in investment
1. Today’s sacrifice
2. Time element
3. Prospective gain
Savings versus Investment

Savings Investment

Short run goals Long run goals

Value remains stable
Lower returns over long term
Good for short term needs
Value moves up (down) in the
short term
Potentially higher return over
long term
Good for long term goals
Speculation
• The act of trading in an asset, or conducting a financial transaction,
that has a significant risk of losing most or all of the initial outlay, in
expectation of a substantial gain.
• Speculator generally uses borrowed money and constructs leveraged
portfolio
• He prefers to buy on margin money/margin trading
• Speculator generally chooses derivative markets
• He may change his position many times even during a day
Investment versus Speculation
1. Investment –outright purchase
Speculation-on margin payment
2. Investment-earnings
Speculation-capital gain
3. Investment-small risk
Speculation-large risk
4. Investment –cautious and conservative
Speculation-daring and careless
5. Investment-scientific analysis and intrinsic worth
Speculation-tips, rumors and inside information
6. Investment-stable income
Speculation-uncertain and erratic
Gambling
• Webster's Dictionary: “Gambling is an act of betting on an uncertain
outcome”

• In gambling the outcome is largely a matter of luck.

• They are risk lovers

EVERY INVESTMENT IS SOMEWHAT GAMBLING

Features of gambling
• Gambling is based on blind chance and not knowledge
• Gambling is typical, chronic and repetitive
• Gambling absorbs all other interest
• Gambler displays persistent optimism
• Gambler never stops after winning
• He takes more risk than he can afford
• He enjoys strange thrill-pleasure and pain
• His time horizon is very very short
• He acts on tips and rumors **
Features of investment
• Safety of the principal
• Marketability
• Liquidity
• Income stability
• Appreciation
• Tangibility
• Tax shelter
• Convenience
Types of investment
• Security or property
• Direct or indirect
• Debt, equity or derivative security
• Low or high risk investments
• Short run or long run investments
• Domestic or foreign investments
Investment Risks
• Purchasing power risk (inflation)
• Market risk/risk of volatility
• Interest rate risk
• Reinvestment rate risk
• Exchange rate risk
• Regulatory risk
• Risk of higher spread-impact cost/Risk of lower liquidity
• Credit risk (risk of default)
• October is one of the peculiarly dangerous months to speculate in stocks.
• Other months are July, January, September, April, November, May, March, June, December,
February and August.
Asset Classes
Real Assets
• Real estate
• Bullions
• Commodities
• Other metals
• Antiques
Financial Assets
• Equity shares
• Fixed income products (time deposits, bonds, debentures etc…)
• Derivatives
• Mutual Funds
The Players
• Business Firms (net borrowers)

• Households (net savers)

• Governments (can be both borrowers and savers)

• Financial Intermediaries (connectors of borrowers and lenders)

• Commercial banks
• Investment companies
• Insurance companies
• Pension funds
• Hedge funds
Capital Market - Meaning
• Capital markets are venues where savings and investments are channeled
between the suppliers who have capital and those who are in need of
capital.
• The entities that have capital include retail and institutional investors and
general public while those who seek capital are businesses and
governments.
• The term capital market broadly defines the place where various entities
trade different financial instruments. These venues may include the stock
market, the bond market, and the currency and foreign exchange markets. 
• Capital markets are used to sell financial products such as equities and
debt securities. Equities are stocks, which are ownership shares in a
company. Debt securities, such as bonds, are interest-bearing certificates.
Capital Market – Types
Capital
Market

Equity Debt
Market Market

Primary Secondary Primary Secondary

Market Market Market Market

Rights Bonus Stock

IPO QIP
Issue Issue Markets

Cash Market Segment Derivative Market Segment

Stock Markets
• The stock market refers to the collection of markets and exchanges
where regular activities of buying, selling, and issuance of shares of
publicly-held companies take place.
• Such financial activities are conducted through institutionalized
formal exchanges or over-the-counter (OTC) marketplaces which
operate under a defined set of regulations.
• There can be multiple stock trading venues in a country or a region
which allow transactions in stocks and other forms of securities.
• There are two segments of services: Cash Market & Derivatives
Markets
Why stock market is exciting for many?
• High Returns
• Liquidity
• Mother of all investments
• Diversification using single avenue
• Highly regulated investment avenue
• To earn steady income
• Easy for retirement planning
• Continuous learning (Good for students)
 Stock Markets in India

There are two important stock exchanges in India which provide capital
market services. They are:

• National Stock Exchange (NSE Estd: 1992)

• BSE Ltd. (Formerly Bombay Stock Exchange. Estd: 1874)

Cash Market Segment
Stock Exchange Mechanism
Depository Participants
• Central Depository Services Ltd. (CDSL) for BSE
• National Securities Depository Ltd. (NSDL) for NSE
Grouping of Stocks
• BSE
oA
oB
oT
oZ
o F/G
Indices

BSE NSE
S&P BSE Sensex NIFTY 50
S&P BSE Sensex 50 NIFTY NEXT 50
S&P BSE100 NIFTY 100
S&P BSE Sensex Next 50 NIFTY 200
S&P BSE Midcap NIFTY 500
Sectoral Indices Sectoral Indices
Some market terminologies
• Bull & Bull Market
• Bear & Bear Market
• Rolling Settlement
• Long Position
• Short Position
• Ask (Buy Price)
• Bid (Sell Price)
• Bid – Ask Spread
• Trade To Trade (Compulsory
Delivery)
• Volume
• Value
• Volatility
• Market Capitalization
• Large Cap Stock (More than Rs. 20000 crore)
• Mid Cap Stock (Rs. 5000 – 20000 crore)
• Small Cap Stock (Upto Rs. 5000 crore)
• Portfolio
• Blue Chip Companies (Other types include
Growth/income/cyclical/Defensive)
• Circuit Breakers
Types of Orders
• Market Order (Buy or Sell)
• Limit Order
• Day Order
• GTC Order
• Stop Loss Order
Order Mechanism and Types
• BSE & NSE follows an Order Driven System through fully automated
trading mechanism.
• BSE uses – BOLT (Bombay Online Trading) Mechanism for trading
• NSE uses – NEAT (National Exchange for Automated Trading)
• The orders placed by a buyer or seller through the AD will be
automatically matched using the above systems.
• The exchanges uses Rolling Settlement for transferring the stocks and
funds.
• T+2 days are considered for rolling settlement. (National Clearing Ltd
– NSE & ICCL - Indian Clearing Corporation Ltd. – BSE)
 Stock Market Index
• The general movement of the stock market is usually
measured by averages or indices consisting of groups
of securities that are supposed to represent the
entire market or particular segment of it.
• It provides the summary measure of the behavior of
security prices.
• An index is calculated with reference to a base
period and a base index value
 Uses of index
1. They provide a historical comparison of returns on
money invested in the stock market
2. As a bench mark to evaluate the performance of
a fund manager
3. To create and maintain the index fund &index
derivatives
4. To depict up to date information
5. It is a lead indicator of the performance of the
economy
6. For calculating beta values
7. For creating the synthetic index fund
8. Exchange Traded Funds
 Construction of an index
1. The choice of the base year
2. Sample size
3. Representativeness
4. Selection of stocks
5. Weighting
Price weighted, Value weighted & Equal weighted index
 Limitations of index
1. Index is influenced by few heavy weights. It may
not represent the entire market.
2. Most of the indices do not consider total returns
3. Index is based on a very small sample of the
universe. So it may not really reflect the entire
market
4. The base year selected should be a normal year
5. There is a constant need to adjust the base
values due to M&A, Sell-off, spin-off, rights,
public issues etc.
Choices in Index Construction and Management
Which target market should the index represent?

Which securities should be selected from that target market?

How much weight should be allocated to each security in the index?

When should the index be rebalanced?

When should the security selection and weighting decision be re-

examined?
 Target Market Selection

Defined broadly
or narrowly?

Other Based on an
characteristics? asset class?
Target
market

Based on
Based on an
geographic
exchange?
region?
Different Weighting Methods Used in Index
Construction
Market
Equal
capitalization
weighted
weighted

Fundamentally
Price weighted
weighted
Index
weighting
 NIFTY 50 Index
• The NIFTY 50 is the flagship index on the National Stock Exchange of India Ltd.
(NSE). The Index tracks the behavior of a portfolio of blue chip companies, the
largest and most liquid Indian securities.
• It includes 50 of the approximately 1600 companies traded (listed & traded and
not listed but permitted to trade) on NSE, captures approximately 65% of its float-
adjusted market capitalization and is a true reflection of the Indian stock market.
• The NIFTY 50 covers major sectors of the Indian economy and offers investment
managers exposure to the Indian market in one efficient portfolio.
• The Index has been trading since April 1996 and is well suited for benchmarking,
index funds and index-based derivatives.
• The NIFTY 50 is owned and managed by NSE Indices Limited (formerly known as
India Index Services & Products Limited-IISL), India’s first specialized company
focused on an index as a core product.
NIFTY 50 Index (contd.)
• The NIFTY 50 Index represents about 65% of the free float market
capitalization of the stocks listed on NSE as on March 31, 2021.
• The total traded value of NIFTY 50 index constituents for the last six
months ending March 2021 is approximately 43.8% of the traded
value of all stocks on the NSE.
• For inclusion in the index, the security should have traded at an
average impact cost of 0.50 % or less during the last six months for
90% of the observations for a portfolio of Rs. 10 crores.
• NIFTY 50 is ideal for derivatives trading.
Method of Computation
• NIFTY 50 is computed using free float market capitalization weighted method,
wherein the level of the index reflects the total market value of all the stocks in
the index relative to a particular base period.
• The method also takes into account constituent changes in the index and
importantly corporate actions such as stock splits, rights, etc without affecting the
index value.
• The base period selected for NIFTY 50 index is the close of prices on November 3,
1995, which marks the completion of one year of operations of NSE's Capital
Market Segment.
• The base value of the index has been set at 1000 and a base capital of Rs.2.06
trillion.
Method of Computation (contd.)
• Eligible Securities:
• Constituents of NIFTY 100 index that are available for trading in NSE’s Futures
& Options segment are eligible for inclusion in the NIFTY 50 index
• Liquidity (Impact Cost)
• For inclusion in the index, the security should have traded at an average
impact cost of 0.50% or less during the last six months for 90% of the
observations for a basket size of Rs. 10 Crores.
Impact Cost and its calculation
• Liquidity in the context of stock markets means a market where large orders can be executed
without incurring a high transaction cost. The transaction cost referred here is not the fixed
costs typically incurred like brokerage, transaction charges, depository charges etc. but is the
cost attributable to lack of market liquidity as explained subsequently.
• Liquidity comes from the buyers and sellers in the market, who are constantly on the look
out for buying and selling opportunities. Lack of liquidity translates into a high cost for
buyers and sellers.
• The electronic limit order book (ELOB) as available on NSE is an ideal provider of
market liquidity. This style of market dispenses with market makers, and allows anyone in
the market to execute orders against the best available counter orders. The market may thus
be thought of as possessing liquidity in terms of outstanding orders lying on the buy and sell
side of the order book, which represent the intention to buy or sell.
• When a buyer or seller approaches the market with an intention to buy a particular stock, he
can execute his buy order in the stock against such sell orders, which are already lying in the
order book, and vice versa.
Order Book
BID ASK
Sr. No. Quantity Price Quantity Price Sr. No.
1 1000 3.50 2000 4.00 5
2 1000 3.40 1000 4.05 6
3 2000 3.40 500 4.20 7
4 1000 3.30 100 4.25 8

There are four buy and four sell orders lying in the order book. The difference between the best buy and the
best sell orders (in this case, 0.50) is the bid-ask spread. If a person places an order to buy 100 shares, it would
be matched against the best available sell order at 4 i.e. he would buy 100 shares for 4. If he places a sell
order for 100 shares, it would be matched against the best available buy order at 3.50 i.e. the shares would be
sold at 3.5.
Impact Cost
Suppose a person wants to buy and then sell 3000 shares. The sell order will hit the
following buy orders:
Sr. No. Quantity Price
1 1000 3.50
2 1000 3.40
3 1000 3.40

While the buy order will hit the following sell orders:
Quantity Price Sr. No.
2000 4.00 5
1000 4.05 6
Impact Cost
• This implies an increased transaction cost for an order size of 3000 shares in
comparison to the impact cost for order for 100 shares. The "bid-ask spread"
therefore conveys transaction cost for a small trade.
• This brings us to the concept of impact cost. We start by defining the ideal price as
the average of the best bid and offer price, in the above example it is (3.5+4)/2, i.e.
3.75.
• In an infinitely liquid market, it would be possible to execute large transactions on
both buy and sell at prices which are very close to the ideal price of 3.75.
• In reality, more than 3.75 per share may be paid while buying and less than 3.75
per share may be received while selling.
• Such percentage degradation that is experienced vis-à-vis the ideal price, when
shares are bought or sold, is called impact cost. Impact cost varies with transaction
size.
Calculation of Impact Cost

For example, in the above order book, a sell order for 4000 shares will be executed as follows:

Sr. No. Quantity Price Value

1 1000 3.50 3500
2 1000 3.40 3400
3 2000 3.40 6800
Total value 13700
Wt. average price 3.43

The sale price for 4000 shares is 3.43, which is 8.53% worse than the ideal price of 3.75. Hence we say "The
impact cost faced in buying 4000 shares is 8.53%".
Impact Cost
• Impact cost represents the cost of executing a transaction in a given stock, for a
specific predefined order size, at any given point of time.
• Impact cost is a practical and realistic measure of market liquidity; it is closer to
the true cost of execution faced by a trader in comparison to the bid-ask spread.
• It should however be emphasized that:
• impact cost is separately computed for buy and sell
• impact cost may vary for different transaction sizes
• impact cost is dynamic and depends on the outstanding orders
• where a stock is not sufficiently liquid, a penal impact cost is applied
• In mathematical terms it is the percentage mark up observed while buying / selling
the desired quantity of a stock with reference to its ideal price (best buy + best
sell) / 2.
 Impact Cost for buying 1500 shares

ORDER BOOK SNAPSHOT

Buy Quantity Buy Price Sell Quantity Sell Price

1000 98 1000 99

2000 97 1500 100

1000 96 1000 101

Method of NIFTY Computation….
• Float-Adjusted Market Capitalization: Companies will be eligible for inclusion in NIFTY
50 index provided the average free-float market capitalization is at least 1.5 times the
average free-float market capitalization of the smallest constituent in the index.
• Listing History: A company which comes out with an IPO is eligible for inclusion in the
index if it fulfills the normal eligibility criteria for the index - impact cost, float-adjusted
market capitalization for a three-month period instead of a six-month period.
• At the time of index reconstitution, a company which has undergone a scheme of
arrangement for corporate event such as spin-off, capital restructuring etc. would be
considered eligible for inclusion in the index if as on the cut-off date for sourcing data
of preceding six months for index reconstitution, a company has completed three
calendar months of trading period after the stock has traded on ex. basis subject to
fulfilment of all eligibility criteria for inclusion in the index.
Method of NIFTY Computation….
• Trading Frequency: The company’s trading frequency should be 100% in the last six months.
• Index Reconstitution: The index is reconstituted semi-annually considering 6 months data ending January
and July respectively. The replacement of stocks in NIFTY 50 (if any) is generally implemented from the first
working day after F&O expiry of March and September.
• In case of any replacement in the index, a four weeks’ prior notice is given to the market participants.
Additional index reconstitution may be undertaken in case any of the index constituent undergoes a scheme
of arrangement for corporate events such as merger, spin-off, compulsory delisting or suspension etc.
• The equity shareholders’ approval to a scheme of arrangement is considered as a trigger to initiate the
exclusion of such stock from the index through additional index reconstitution.
• Further, on a quarterly basis indices will be screened for compliance with the portfolio concentration norms
for ETFs/ Index Funds announced by SEBI on January 10, 2019. In case of non-compliance, suitable corrective
measures will be taken to ensure compliance with the norms.
• As part of the semi-annual reconstitution of the index, a maximum of 10% of the index size (number of
companies in the index) may be changed in a calendar year. However, the limit of maximum 10% change shall
not be applicable for any exclusion of a company on account of scheme of arrangement as stated above
Investible Weight Factors (IWFs):
• IWF as the term suggests is a unit of floating stock expressed in terms of a number available for
trading and which is not held by the entities having strategic interest in a company.
• Higher IWF suggest greater number of shares held by the investors as reported under public
category within a shareholding pattern reported by each company.
• The IWFs for each company in the index are determined based on the public shareholding of the
companies as disclosed in the shareholding pattern submitted to the stock exchanges on quarterly
basis accumulated and implemented on quarterly basis from March, June, September and
December effective after the expiry of the F&O contracts..
• The following categories are excluded from the free float factor computation:
• Shareholding of promoter and promoter group
• Government holding in the capacity of strategic investor
• Shares held by promoters through ADR/GDRs.
• Strategic stakes by corporate bodies
• Investments under FDI category
• Equity held by associate/group companies (cross-holdings)
• Employee Welfare Trusts
• Shares under lock-in category
Price Index Calculation
• The NIFTY 50 is computed using the free-float market capitalization weighted method
wherein the level of the Index reflects the total market value of all the stocks in the Index
relative to the base period November 3, 1995.
• The total market cap of a company or the market capitalization is the product of market
price and the total number of outstanding shares of the company.
• Market Capitalization = Shares outstanding * Price
• Free Float Market Capitalization = Shares outstanding * Price * IWF
• Index Value = Current Market Value / Base Market Capital * Base Index Value (1000)
• Base market capital of the Index is the aggregate market capitalization of each scrip in
the Index during the base period.
• The market cap during the base period is equated to an Index value of 1000 known as
the base Index value.
Analysis of Risk and Return
Risk and Returns
• Income received on an investment plus any change in market price,
usually expressed as a percent of the beginning market price of the
investment.
• The variability of returns from those that are expected.
• What rate of return do you expect on your investment (savings) this
year?
• What rate will you actually earn?
• Does it matter if it is a bank deposits or equity or gold?
Sources of Investment returns
• Dividends, Interest
• Cash dividends on common, preferred stock
• Interest (coupons) on Bills and Bonds
• Capital gains/losses (Realized vs. Paper)
• Increases/decreases in price
• Other
• Stock Dividends
• Rights and Warrants
 Return on Financial Assets

Total Return

Periodic Capital Gain or

Income Loss
Measuring Total Return
• The total return for an investment in the given period would be:
TR = Cash Payment received during the period + Price Change over the period /
Price of the investment at the beginning

Suppose:
• Price at the beginning is ₹100 & the asset was sold at ₹150 the total
dividend received during the period is ₹20. Then the total return
would be…..
Holding Period Returns
• The return realized by an investor during a real or expected period of
time, holding period return is calculated as income plus price
appreciation during a specific time period, divided by the
investment‘s cost. 
Pt  Pt 1  CFt
HPR t 
Pt 1
• Where: Pt = current price
Pt-1 = purchase price
CFt = cash flow received in time t
105  100 2
R   5%  2%  7%
100 100
Holding Period Returns
• What is the 3-year holding period return if the annual returns are 7%,
9%, and –5%?

R  1  R1  1  R2  1  R3   1
 1  .07 (1  .09)(1  .05) 1  .1080  10.80%
Cumulative Wealth Index
• The CWI measures the cumulative effect of total return.
• CWI = WI (1+R1) (1+R2) (1+R3)……… (1+Rn)
• WI = Beginning Index Value = 1
• Consider a stock which earns 14%, 15%, 12%, -8% and 20% in the last
5 years. Then the CWI would be: ………
• To find the Total Return for a given period using the CWI then one can
use the following formula:
• Rn = (CWIn/CWIn-1) - 1
Summary Statistics
• Arithmetic average
• Sum of returns in each period divided by number of periods
• Geometric average
• Single per-period return
• Gives same cumulative performance as sequence of actual
returns
• Compound period-by-period returns
Rates of Return of a Mutual Fund: Example

1st Quarter 2nd Quarter 3rd Quarter 4th Quarter

Assets under management at start of quarter 1 1.2 2 0.8
Holding-period return (%) 10 25 −20 20
Total assets before net inflows 1.1 1.5 1.6 0.96
Net inflow ($ million) 0.1 0.5 −0.8 0.6
Assets under management at end of quarter 1.2 2 0.8 1.56

Arithmetic Average Geometric Average

10%  25%  ( 20%)  20% 1
 8.75% [(1.1)  (1.25)  (.8)  (1.2)]  1  7.19%
4
4
Illustration
• Following information provided about three stocks:

Stock Beginning Ending Dividend TR TR % Return

Price Price Relative =
1+TR%
A 30 34 3.40 7.40 24.67% 1.2467
B 72 69 5 2 2.78% 1.0278
C 140 146 10 16 11.43% 1.1143

• AM = (0.2467+0.0278+0.1143)/3 = 12.96%
• GM = [(1.2467)X(1.0278)X(1.1143)]^1/3 - 1 = 12.60%

• Calculate Total Return, Return Relative, AM & GM.

Rates of Return

• Annualizing Rates of Return

• APR = Annual Percentage Rate
• Per-period rate × Periods per year
• Ignores Compounding
• EAR = Effective Annual Rate
• Actual rate an investment grows
• Does not ignore compounding
Rates of Return: EAR vs. APR
For n periods of compounding:
APR n
EAR  (1  ) 1
n
1
APR  [( EAR  1)  1]  n
n

where
n  compounding per period

For Continuous Compounding:

EAR  e APR  1
APR  ln( EAR  1)
Illustrations
• Find the APR if the EAR is 9% and compounded continuously.
• What is the EAR if the APR is 9% and compounded Continuously?
• What is the APR if the EAR is 9% and compounded monthly?
• What is the EAR if the APR is 10% and compounded semi annually?
• What is the EAR if the APR is 10 and compounded continuously?
• What is the real interest rate if the nominal rate of interest is 8% and
inflation rate is 5%?
• What is the inflation rate if the real interest rate is 9% and nominal
rate of interest is 10%?
Real Return
• Real rate of return is the annual percentage of profit earned on an investment,
adjusted for inflation. Therefore, the real rate of return accurately indicates the
actual purchasing power of a given amount of money over time.
• Adjusting the nominal return to compensate for inflation allows the investor to
determine how much of a nominal return is real return.
• In addition to adjusting for inflation, investors also must consider the impact of
other factors, such as taxes and investing fees, to calculate real returns on their
money or to choose among various investing options.
Inflation and The Real Rates of Interest
• Nominal Interest and Real Interest
1 R
1 r 
1 i
where
r  Real Interest Rate
R  Nominal Interest Rate
i  Inflation Rate

Example : What is the real return on an investment that earns a nominal 10%
return during a period of 5% inflation?
1  .10
1 r   1.048
1  .05
r  .048 or 4.8%
 Gross and Net Returns

Gross returns Expenses Net returns

 Pre-Tax and After-Tax Nominal Return

After-tax
Pre-tax nominal
Taxes nominal
return
return
Measures of Risk
Measures of Risk
• Risk refers to the probability that the actual outcome of an
investment will differ from the expected outcome. Risk also refers to
variability and dispersion.
• If a asset’s return has no variability it is riskless.
• What causes uncertainty?
• Can it be managed?
Standard Deviation
• The standard deviation is a statistic that measures the dispersion of a
dataset relative to its mean and is calculated as the square root of the
variance.
• It is calculated as the square root of variance by determining the
variation between each data point relative to the mean.
• If the data points are further from the mean, there is a higher
deviation within the data set; thus, the more spread out the data, the
higher the standard deviation.
Standard Deviation (Contd.)
• Standard deviation is a statistical measurement in finance that, when
applied to the periodic rate of return of an investment, sheds light on
the historical volatility of that investment.
• The greater the standard deviation of securities, the greater the
variance between each price and the mean, which shows a larger
price range.
• For example, a volatile stock has a high standard deviation, while the
deviation of a stable blue-chip stock is usually rather low.
Variance
• Variance is a measurement of the spread between numbers in a data
set.
• Investors use variance to see how much risk an investment carries
and whether it will be profitable.
• Variance is also used to compare the relative performance of each
asset in a portfolio to achieve the best asset allocation.
• Variance is often depicted by this symbol: σ2. It is used by both
analysts and traders to determine volatility and market security.
• The square root of the variance is the standard deviation (σ), which
helps to determine the consistency of an investment’s returns over a
period of time.
Coefficient of variation (CV)
• The coefficient of variation (CV) is a statistical measure of the
dispersion of data points in a data series around the mean.
• The coefficient of variation represents the ratio of the standard
deviation to the mean, and it is a useful statistic for comparing the
degree of variation from one data series to another, even if the means
are drastically different from one another.
Coefficient of variation (CV)
• In finance, the coefficient of variation allows investors to determine
how much volatility, or risk, is assumed in comparison to the amount
of return expected from investments.
• The lower the ratio of standard deviation to mean return, the better
risk-return trade-off.
• Note that if the expected return in the denominator is negative or
zero, the coefficient of variation could be misleading.
Illustration on SD & CV
Period Return

1 15
2 12
3 20
4 -10
5 14
6 9
Understanding SD
• Suppose an asset has an average yearly return of 10% and a standard
deviation of 15%. Based on the above definition, we can expect its annual
performance will fall within the -5% to +25% range about 2/3 of the time
(every two out of three years).
• And about 95% of the time (19 out of 20 years), returns should lie within
the bounds of -20% and +40% (two standard deviations). This shows the
magnitude of loss in an unusual year.
• Standard deviation is a statistical measurement of how far a variable,
such as an investment’s return, moves above or below its average
(mean) return. 
• An investment with high volatility is considered riskier than an investment
with low volatility; the higher the standard deviation, the higher the risk.
Understanding CV
• The three potential investments being scrutinized here are a stock called XYZ,
a broad market index named DEF, and bond ABC. A quick use of the COV
formula shows the following:
• Stock XYZ has volatility, or standard deviation, of 15% and an expected return of
19%. That means the COV is 0.79 (15% ÷ 19%).
• The broad market index fund DEF has a standard deviation of 8% and an
expected return of 19%. The coefficient of variation is 0.42 (8% ÷ 19%).
• The third investment, bond, ABC, has a volatility of 5% and an expected return
of 8%. The coefficient of variation therefore is 0.63 (5% ÷ 8%).
• The investor would probably choose to invest in the broad market index DEF
because it offers the best risk/reward ratio and the lowest volatility
percentage per unit of return.
Expected Return of the Stock
• The expected return is the profit or loss that an investor
anticipates on an investment that has known historical rates of
return (RoR).
• It is calculated by multiplying potential outcomes by the chances
of them occurring and then totaling these results.
• Expected returns cannot be guaranteed.
• The expected return for a portfolio containing multiple investments
is the weighted average of the expected return of each of the
investments.
Illustration
• Calculate the expected rate of return from the following information
relating to B Ltd.
State of the Economy Probability Return
Boom 0.30 40%
Normal 0.50 30%
Recession 0.20 10%
SD of Expected Returns with probability
• Calculate the SD of return from the following information relating to B
Ltd.
State of Probabilit Return pixri Ri-er 2
the y
Economy
Boom 0.30 40% 12 11 121 36.3
Normal 0.50 30% 15 1 1 0.5
Recessi 0.20 10% 2 = 29 -19 361 72.2
on
The Normal Distribution
• The stock returns are expected to be normally distributed over a
period of time.
• The normal distribution is characterized by just two parameters i.e
expected return and SD of variation.
• A bell shaped distribution, it is perfectly symmetric around the
expected return.
• The probability for values lying within the bands around the expected
return are as below;
• +/- One standard deviation = 68.3% probability
• +/- Two SD = 95.4%
• +/- Three SD = 99.7%
Normal Distribution r = 10% and σ = 20%
Deviation from Normality and Value at Risk
• Kurtosis: Measure of fatness of tails of probability
distribution; indicates likelihood of extreme outcomes
• Skew: Measure of asymmetry of probability distribution
Now compare the distribution of the returns
Risk and Risk Premiums
• Risk Premiums and Risk Aversion
• Risk-free rate: Rate of return that can be earned with certainty
• Risk premium: Expected return in excess of that on risk-free
securities
• Excess return: Rate of return in excess of risk-free rate
• Risk aversion: Reluctance to accept risk
• Price of risk: Ratio of risk premium to variance