Security Analysis and Portfolio Management-

Dr. Prof. Nirmala Joshi

 Learning Outcome
• To understand the concept of risk
1

• To know the various types of risk

2

• To comprehend risk measurement

3 tools

Dr. Prof. Nirmala Joshi

 Recap of Session 2
 Portfolio Management –
 Different Asset Classes
 Risk- Types of Risks
 Calculation of Risk- Standard Deviation & Beta
 Calculation
Why to study SAPMof return from Share Prices
What to study in
How to study
SAPM

Dr. Prof. Nirmala Joshi

 Recap of Session 3
Price, Return and Risk relationship
Calculation of stock returns –
• Profit
• Return- HPR
• Nominal Return, Real Return, Fully equitable Tax returns
• Return with Dividend
• Estimation of Return-
– Arithmetic Mean & Geometric Mean
– Annualized Expected Return- crude and compound
– Probability based expected return

Dr. Prof. Nirmala Joshi

Chapter 2 Risk and Return
Analysis

Dr. Prof. Nirmala Joshi

“A blindfolded monkey throwing darts at a
newspaper’s financial pages could select a portfolio
that would do just as well as one carefully selected
by experts.”

- Burton Malkiel,
- A Random Walk Down Wall Street.

Dr. Prof. Nirmala Joshi

 Estimated Return
• Perhaps the biggest limitation of the mean
based Expected Return is the fact that it relies
solely on historic data / information.
• Forward looking expected returns -We could
overcome this by estimating ‘State
Contingent’ Expected Returns or by using
Asset Pricing Models.

Dr. Prof. Nirmala Joshi

 Forward looking expected returns
-‘State Contingent’ Expected
Returns

• Recap: Expected Returns (Mean) Perhaps the

biggest limitation of the mean based Expected
Return is the fact that it relies solely on
historic data / information.

Dr. Prof. Nirmala Joshi

Future probability Based Return/SCER/FLER

• This way, we incorporate the (subjective)

probabilities of future events occurring. And
estimate expected returns conditional on
those events / ‘states
• State Contingent Expected Returns are only as
good as the accuracy of:
– The anticipated returns, and
– The probabilities of occurrences.’ occurring.

Dr. Prof. Nirmala Joshi

 Asset Pricing Models
• Asset Pricing Models remove some of the
subjective issues involved in the estimation of
Expected Returns.
• Forward looking expected returns can be
computed using ‘state contingent’ weighted
probabilities.
• The estimate is only as good as the estimates
for anticipated returns and probabilities of
states occurring
Dr. Prof. Nirmala Joshi
EXPECTED RETURNS USING ASSET
PRICING MODELS - CAPM

Dr. Prof. Nirmala Joshi

 Expected Returns Using Asset Pricing
Models - CAPM

We can estimate the expected return by...

• Using the stock’s historic average return.
• Using state-contingent weighted probabilities.
• Using Asset Pricing Models

Dr. Prof. Nirmala Joshi

 What are ‘Asset Pricing Models’?
• Asset Pricing Models are tools that use math
and logic to determine the expected return of
financial securities.
• At a fundamental level, they rely on linearity,
perfect information, and ‘efficient markets’.

Dr. Prof. Nirmala Joshi

 Assumptions of Asset Pricing Models

1. Linearity: Equation of a straight line

y= a + bx………linear regression
Y=Dependent variable
X = Independent variable
a = Intercept term (value of Y when X = 0)
b = Slope (impact on Y when X changes)
.

Dr. Prof. Nirmala Joshi

Simple Regression of Y on X

Dr. Prof. Nirmala Joshi

 2. Assumption – Efficient Market
• The models assume all investors have the
same information, and everyone has the
‘right’ information.
• The models assume markets are ‘efficient’, so
that all information is immediately reflected in
the prices of securities.

Dr. Prof. Nirmala Joshi

Generalized Asset Pricing Model

Dr. Prof. Nirmala Joshi

CAPITAL ASSET PRICING MODEL IS
IN PORTFOLIO THEORIES
SO WE WILL DISCUSS LATER….

Dr. Prof. Nirmala Joshi

Efficient Market Hypothesis

Dr. Prof. Nirmala Joshi

Chapter 3 Efficient Market Theory

https://www.youtube.com/watch?v=_vdB7gphtyo
Monkey Business stock market

Dr. Prof. Nirmala Joshi

 History of the Random-Walk Theory
French mathematician, Louis Bachelier in 1900
wrote a paper suggesting that security price
fluctuations were random.
In 1953, Maurice Kendall in his paper reported
that stock price series is a wandering one.
Each successive change is independent of the
previous one.
In 1970, Fama stated that efficient markets
fully reflect the available information.
Dr. Prof. Nirmala Joshi
Dr. Prof. Nirmala Joshi
 EMH/EMT- Basic assumptions
Efficient market theory states that the share
price fluctuations are random and do not
follow any regular pattern.
The expectations of the investors regarding
the future cash flows are translated or
reflected on the share prices.
The accuracy and the quickness in which the
market translates the expectation into prices
are termed as market efficiency.
Dr. Prof. Nirmala Joshi
 Assumptions
• Full disclosure and transparency
• Free flow of information
• Large number of investors
• Prices reflect information effect
• No one can influence the market unduly

Dr. Prof. Nirmala Joshi

 Types of Market Efficiencies
 Operational efficiency: Operational efficiency is
measured by factors like time taken to execute the
order and the number of bad deliveries. Efficient
market hypothesis does not deal with this efficiency.
 Informational efficiency: It is a measure of the
swiftness or the market’s reaction to new information.
 New information in the form of economic reports, company
analysis, political statements and announcement of new
industrial policy is received by the market frequently.
 Security prices adjust themselves very rapidly and
accurately.

Dr. Prof. Nirmala Joshi

 Forms of Efficiencies
They are divided into three categories:
 Weak form
 Semi-strong form
 Strong form

The level of information being considered in the

market is the basis for this segregation.

Dr. Prof. Nirmala Joshi

 Market Efficiency
Strongly efficient market
All information is reflected
on prices.

Semi-strong efficient market

All public information is
reflected on security prices

Weakly efficient market

All historical information
is reflected on security
prices.
Levels of Information and the Markets
Dr. Prof. Nirmala Joshi
Market Efficiency

Dr. Prof. Nirmala Joshi

 Weak Form of EMH
 Current prices reflect all information found in the
volumes.

 Future prices can not be predicted by analyzing the

prices from the past.

 Buying and selling activities of the information

traders lead the market price to align with the
intrinsic value.

Dr. Prof. Nirmala Joshi

 Semi-Strong Form
 The security price adjusts rapidly to all publicly
available information.
 The prices not only reflect the past price data, but
also the available information regarding the earnings
of the corporate, dividend, bonus issue, right issue,
mergers, acquisitions and so on.
 The market has to be semi-strongly efficient, timely
and correct dissemination of information and
assimilation of news are needed.

Dr. Prof. Nirmala Joshi

 Strong Form
All information is fully reflected on security
prices.
It represents an extreme hypothesis which
most observers do not expect it to be literally
true.
Information whether it is public or inside
cannot be used consistently to earn superior
investors’ return in the strong form.

Dr. Prof. Nirmala Joshi

Empirical Tests for “Weak form of Market”
 Filter rule:
 According to this strategy if a price of a security rises by atleast x per cent,
investor should buy and hold the stock until its price declines by atleast x
per cent from a subsequent high.
 Several studies have found that gains produced by the filter rules were
much below normal than the gains of the simple buy and hold strategy
adopted by the investor.
 Runs test:
 It is used to find out whether the series of price movements have occurred
by chance.
 A run is an uninterrupted sequence of the same observation.
 Studies using runs test have suggested that runs in the price series of
stocks are not significantly from the run in the series of random numbers.
 Auto / Serial correlation:
 Serial correlation or auto-correlation measures the correlation co-efficient
in a series of numbers with the lagging values of the same series.
 Many studies conducted on the security price changes have failed to show
any significant correlations.
Dr. Prof. Nirmala Joshi
Dr. Prof. Nirmala Joshi
Dr. Prof. Nirmala Joshi
Event Impact- Bad News

Dr. Prof. Nirmala Joshi

Event impact – good News

Dr. Prof. Nirmala Joshi

Trading Day Price returns
1
2
154
151 -1.95% 1. Filter Test
3 149 -1.32%
4 149 0.00%Buy
5 147 -1.34%plus 3% 151.41
6 148 0.68%
7 153 3.38%
8 153 0.00% Very simple – no
9 154 0.65%
10 154.7 0.45% complex calculations
11 155.2 0.32%
12 156 0.52%
13 158 1.28%Sell
14 162 2.53%minus 3% 157.14
15 161.5 -0.31%
16 161.2 -0.19%
17 161 -0.12%
18 159.5 -0.93%
19 158 -0.94%
20 157 -0.63%
Dr. Prof. Nirmala Joshi
Dr. Prof. Nirmala Joshi
 2. Run Test
Steps 1. collect share prices and find +/- changes
in the prices
2. A Null hypo. About independence of prices is
assumed
3. Find out number of ‘ runs’ i.e. positive and
negative trends
4. Count each type of run as n1(+) and n2(- )

Dr. Prof. Nirmala Joshi

 Run test …..

Calculate mean and Standard deviation with

above formula and limits with = mean+/- 2 SD
Of Z value for significance level
If observed runs are within limit= Ho accepted
otherwise Ho rejected
Dr. Prof. Nirmala Joshi
Dr. Prof. Nirmala Joshi
 3. Auto Co-relation Test
1. In 1964, Moore Took up a test called Serial
Correlation Test
2. Then Fama tested it in 1965 and used in EMH
3. Calculate the relationship with time lag – if there
is any relationship means markets are having
weak efficiency

Dr. Prof. Nirmala Joshi

 4. Residual Analysis
Based on regression projections if total of
residuals is near to Zero then – markets are
efficient

Dr. Prof. Nirmala Joshi

 5. Event study
• First find Regression equation
• Calculate Abnormal returns for different
periods = Expected return- actual return
• Calculate average of each time period and
add all values to check final abnormal return if
it is more than 0 then markets are not efficient

Dr. Prof. Nirmala Joshi

Dr. Prof. Nirmala Joshi
 Assignment
1. Apply Filter test at 3% change in your company
data
2. Apply run test at 20% level of significance i.e.
80% level of confidence
3. Apply auto correlation on the data
4. Apply Residual Analysis
CA students
• https://www.youtube.com/watch?v=lTTNwqX2-
7U&ab_channel=KhetanEducation

Dr. Prof. Nirmala Joshi

 Efficient Market hypo in excel
• https://www.uniassignment.com/essay-sampl
es/finance/hypothesis-test-for-calculation-in-e
xcel-finance-essay.php
• https://www.youtube.com/watch?v=YWlod6J
du-k
Run test
• https://www.youtube.com/watch?v=2uk5gicN
gp8
• https://www.youtube.com/watch?
v=AufPoEKaoDM
Dr. Prof. Nirmala Joshi
Investors & Markets……

Dr. Prof. Nirmala Joshi

 Price, Risk, and Return share
incredibly powerful relationships.

• Knowing and fully understanding these

relationships is crucial for great
Investment/Security Analysis & Portfolio
Management.

Dr. Prof. Nirmala Joshi

 Consider 2 identical stocks
A ltd. B Ltd.
Expected Return 10% 10%
Risk 15% 15%
Price Rs. 100 ???

A ltd. B Ltd.
Expected Return 10% 10%
Risk 15% 15%
Price Rs. 100 110

Rational investors would either ‘go long’ (buy) A ltd. at Rs. 100, or
‘short’ (sell) B Ltd. at Rs. 110. Or hedge their risk by doing both.
Dr. Prof. Nirmala Joshi
 Consider 2 identical stocks
A ltd. B Ltd. (I) B Ltd. (II)
Expected Return 10% 10% 10%
Risk 15% 20% 8%
Price Rs. 100 Rs. <100 Rs. >100

The fair price for. B Ltd. (II) should be greater

than Rs. 100 because safer assets are worth
more than riskier assets.
The ‘value’ of an asset increases as the ‘risk’
decreases. And conversely, the value of an
asset decreases as the risk increases.
Dr. Prof. Nirmala Joshi
 An important relationship

Risk and (expected) return however,

maintain a proportional relationship.
Risk Expected Prices
Returns
Increases Increases Decreases

Decreases Decreases Increases

Dr. Prof. Nirmala Joshi

Price, Risk and Return Relationship

Dr. Prof. Nirmala Joshi

Price, Risk, and Return - Incredibly Powerful
Relationships
1. Direct
Relationship
between Risk and
Return
(A) High Risk - High
Return
(B) Low Risk - Low
Return
2. Negative
Relationship
between Risk and
Return
(A) High Risk Low
Return
(B) Low Risk High
Return

Dr. Prof. Nirmala Joshi

Financial Risk Pyramid

Dr. Prof. Nirmala Joshi

 Calculating Stock Returns
• Return refers to the amount of money you
make from your investment, expressed in %
terms.

• Profit shows you the $ / £ / Rs. you earn from

an investment. Return shows you the same
information in % terms.

Dr. Prof. Nirmala Joshi

 1. Profit & Return
• Profit = Selling Price –
Purchase Price
• Profit = Pt+1 – Pt

Selling Price =120

Purchase Price = 100
Return = 20%
Dr. Prof. Nirmala Joshi
 2. Return of a stock-
Holding Period Return(HPR)

Dr. Prof. Nirmala Joshi

 3. Returns With Dividends
Profit = Selling Price(t+1) + Dividends – Purchase
Price(t)

Dr. Prof. Nirmala Joshi

4. Return of a stock with Dividend

Dr. Prof. Nirmala Joshi

1. Estimating Expected Returns (Mean)

The simplest
estimate for the
Expected Return is
the stock’s
average historic
return (i.e., the
mean return).

Dr. Prof. Nirmala Joshi

 2. Estimating Expected Returns
Geometric Mean in Excel

In excel calculate-
1. Change in share price
= current price/base day price

2. Go to formulas and select geomean and select above

data input , this will give you GM of changed prices
3. Subtract 1 (or 100 if you have converted it in %)
from the figures to get GM of returns

Dr. Prof. Nirmala Joshi

 3. Annualized Expected Returns (AER)

Convert the figure to an annual Expected Return

by either:
1. Multiplying it by 250 (approximate trading
days in a year) – the crude method.
2. Compounding it over 250 days – the more
‘sophisticated’ method.

Dr. Prof. Nirmala Joshi

Annualized Expected Returns (AER)…..

For. E.g. Average stock return for FB is 0.13% daily , assuming

250 trading days in a year the expected return will be simple
32.5% , compounded 38.37%
Dr. Prof. Nirmala Joshi
 ‘Moving Average’ expected returns.

An alternative approach is to use ‘moving

average’ expected returns.
– 7 days MA
– 30 Days MA

Dr. Prof. Nirmala Joshi

 Nominal Return and Real Return
• Nominal Return = 9%
• Inflation Rate = 7%
• Real return = 9-7=2% in absolute terms
• Real Rate of Return =
(1 + nominal rate)/ (1 + inflation rate ) - 1
= (1.09/1.07) – 1
= 0.0187 or 1.87%

Dr. Prof. Nirmala Joshi

 Fully Equivalent Taxable Yield (FETY)
• Post office bond has a yield of 6%, exempt
from both federal taxes (@30%) and state
taxes @10%.
• To compare this with a corporate bond on
which both federal and state taxes apply,
calculate FETY as
• FETY= Tax free rate/(1-Tax Rate)
• =6%/ ( 1-40%)= 10%

Dr. Prof. Nirmala Joshi

 State Contingent Expected Returns/
Probability based expected returns/
Forward looking expected returns

• Perhaps the biggest limitation of the mean

based Expected Return is the fact that it relies
solely on historic data / information.
• We could overcome this by estimating ‘State
Contingent’ Expected Returns.

Dr. Prof. Nirmala Joshi

Calculation of Probability Based Expected
Return

Scenario Best Case Mid Case Worst Case

Return 18% 6.5% –9%
Likelihood 25% 55% 20%
4.5% 3.575% -1.8% =6.28%

Dr. Prof. Nirmala Joshi

McKinsey report

Dr. Prof. Nirmala Joshi

 Study of 209
companies by
Mckinsey

Dr. Prof. Nirmala Joshi

McKinsey - Risk Assessment in Covid

Dr. Prof. Nirmala Joshi

Dr. Prof. Nirmala Joshi
 EMH
• https://www.youtube.com/watch?
v=BNLPHZjY0pc&ab_channel=AnimatedFinanc
e

Dr. Prof. Nirmala Joshi