Invitational Honorary Introductory Lecture

“ Learning for Life”

SYDENHAM INSTITUTE OF MANAGEMENT
STUDIES AND RESEARCH &
ENTREPRENEURSHIP EDUCATION

Security Analysis & Portfolio Management

Session on Course Coverage

To Students of MMS 2nd Year and PGDM by

GAURAV A PARIKH
CMD, Scriptech Consultancy (I) Pvt Ltd

March-April 2007
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Course Coverage

 Security Analysis & Portfolio Management

 Risk & Return

 Efficient Market Hypothesis

 Capital Asset Pricing Model

 Portfolio Analysis & Selection

 Portfolio Performance Measures

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SECURITY ANALYSIS & PORTFOLIO MANAGEMENT

 Motives for Investing

Pecuniary,Prestige,Power

 Security Analysis
Estimates of Returns and Risks associated with
Available Securities

 Portfolio Management
Estimates of Returns and Risk are compared to
determine allocation of available funds

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RISK & RETURN

What is Return?

That can be Expected

What is Risk ?

That the Realised Return is lower

than the Expected Return

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RISK & RETURN : RETURN COMPONENTS

Return Components

 Periodic Cash Receipts

Interest,Dividend

 Change in Price of Asset

Capital Gain or Loss

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RISK & RETURN : RETURN MEASUREMENT

RETURN MEASUREMENT

Absolute

Income + Price Change

Percentage

Cash Payment Received +/- Period Price Change

Upon

Purchase Price

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RISK & RETURN : RETURN APPLICATION

RETURN APPLICATION

 Arithmetic Return or AR

 Geometric Return or GR

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RISK & RETURN : ARITHMETIC RETURN

 AR….Simple Average Aggregate…alright for

Single Period
 AR of Sensex from 2002 to 2006 is 35.38%
 AR has a distinct flaw for multiple periods…A
Share doubles from Rs 10 to Rs 20 in one year
to give 100% return but falls back to Rs 10 in
the next year which is a 50% fall…therefore AR
for Two years will be 50%...this is wrong as
there has been no real gain

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RISK & RETURN : GEOMETRIC RETURN

 GR….Describes Time rate of Return over Multi

Period
 GR of Sensex from 2002 to 2006 is 33.1%
 GR is the nth root of the product resulting from
multiplying a series of returns together
1/n
 GR=( (1+R1)(1+R2)……(1+Rn) ) -1 where 1 is
the Return Relative…for 10% RR is 1.1..that is
the Investor has received 1.1 relative to every 1
invested…RR is used as Negative Total Returns
cannot be used in Computations

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RISK & RETURN : GEOMETRIC RETURN

 GR reflects compound.cumulative returns over

time
 In our example where first year return is 100%
and second year is a negative 50% the GR will
be computed as follows

First Year RR is 1+100%= 1+1 = 2

Second Year RR is 1 – 50%= 1-0.5 = 0.5
½ ½
Therefore GR =(2*0.5) -1 = (1)-1 = 0

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RISK & RETURN : ELEMENTS OF RISK

ELEMENTS OF RISK

 External,Market,Uncontrollable,Systematic,Undiversifiable

 Internal,Controllable,Specific,Unsystematic,Diversifiable

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RISK & RETURN : MEASUREMENT OF RISK

TRADITIONAL

 Assigning Probabilities to every Outcome

 Multiplying Outcome by Probability to give Expected
Return
 ∑ the result to give Expected Average Return (EAR)
 The Spread of possible outcomes about this EAR gives us
a proxy for Risk
 Two Stocks can have identical returns but different
spreads and thus different risks
 Outcome –Expected Return gives us the dispersion or
spread
 When Spread or Dispersion is multiplied by Probabbility it
gives us a Variance
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RISK & RETURN : MEASUREMENT OF RISK

TRADITIONAL
n
 EAR = ∑ P O
i=1
n
 Variance = ∑ P (O-R)
i=1

 Standard Deviation = Square Root of Variance

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RISK & RETURN : MEASUREMENT OF RISK

CONTEMPORARY

 CAPM

 Concept of Beta as Risk

 Expected Return = Risk Free Return + Specific Equity Premium

 ER = RFR + (Beta * Equity Premium)

 Therefore ER = RFR + Beta( Market rate – RFR)

 Security Market Line (SML)

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EFFICIENT MARKET HYPOTHESIS

 Previous Two Theories of Fundamental (Micro/Macro) and

Technical(Price/Volumes)

 Random Walk…can past stock prices help in predicting future stock prices?....and

can past rates of Returns aid in predicting future rates of Returns

 Forms…Weak , Semi Strong , Strong

 The Weak Form repudiates Technical Analysis in that Current prices reflect all

historical sequences and therefore there is no benefit in forecasting the future

 The Semi Strong Form believes that there is benefit to be derived from

Fundamental Theory for Superior Returns as current prices reflect all historical

sequence + publicly available Information

 The Strong Form goes the whole Hog and says that all Information (including

Insider) is reflected in the Current Price and therefore nobenefit can be derived

from Analysis for Superior Returns

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EFFICIENT MARKET HYPOTHESIS
 Successive Price Changes or Changes in Returns are

independent

 Simulation Tests… 1956 Data…Harry Roberts

compared Simulated Changes in Dow Levels every week and

also Point Changes every week with the Actuals…the graph

was similar

 Serial Corelation Tests ….tests independence of successive

changes in two succesive time periods..Corelation Coefficient

lies between +1(directly corelated and linear graph) and -

1(inversely corelated)…0 implies no relationship

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EFFICIENT MARKET HYPOTHESIS

 Runs Test…to overcome skewness in CC you take only No of

runs where runs = consecutive sequences of signs..ex..---

+0+ = 4 runs

 Filter Tests…directly validates Mechanised Trading

Systems..High Filters miss out early movements although

they cut no of transactions and also lead to fewer false

starts…Low filters have an inverse effect of High Filters

 Tests show that when filters were smallest the strategy

outperformed a simple Buy and Hold Strategy adding validity

to the Random Walk Theory

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CAPM

 Switch to BTI Slides

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PORTFOLIO ANALYSIS & SELECTION & MEASUREMENTS

 MARKOWITZ’S DIVERSIFICATION

 SHARPE RATIO…Computation and Criticism

 TREYNOR INDEX

 JENSEN’S ALPHA

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PORTFOLIO ANALYSIS & SELECTION & MEASUREMENTS

MARKOWITZ’S DIVERSIFICATION

Selection of Inversely Corelated Scrips X & Y to tackle

Systematic Risk and as a Portfolio Optimisation Measure

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PORTFOLIO PERFORMANCE MEASUREMENTS : SHARPE RATIO

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SHARPE RATIO : An illustration

A & B offer higher returns but risk

adjusted shows C as a better choice with

risk free rate at 5%

Asset Av Annual
Return Return Volatility Sharpe
Ratio
A 54.52% 177.2% .279
B 36.91% 68.2% .468
C 25.64% 22.69% .910
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TREYNOR INDEX

Treynor Index

A measure of a portfolio's excess return per unit of risk, equal

to the portfolio's rate of return minus the risk-free rate of
return, divided by the portfolio's beta. This is a similar ratio to
the Sharpe ratio, except that the portfolio's beta is considered
the measure of risk as opposed to the variance of portfolio
returns. This is useful for assessing the excess return from each
unit of systematic risk, enabling investors to evaluate how
structuring the portfolio to different levels of systematic risk will
affect returns.

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TREYNOR INDEX
portfolio return risk free rate

portfolio be
ta

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TREYNOR INDEX
Like the Sharpe ratio, the Treynor ratio does
not quantify the value added, if any, of active portfolio
management. It is a ranking criterion only. A ranking of
portfolios based on the Treynor Ratio is only useful if the
portfolios under consideration are sub-portfolios of a broader,
fully diversified portfolio. If this is not the case, portfolios with
identical systematic risk, but different total risk, will be rated
the same. But the portfolio with a higher total risk is less
diversified and therefore has a higher unsystematic risk which is
not priced in the market.

An alternative method of ranking portfolio management is

Jensen's alpha, which quantifies the added return as the excess
return above the security market line in the
capital asset pricing model.

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JENSEN’S ALPHA

Jensen's alpha

In finance, Jensen's alpha (or Jensen's

Performance Index) is used to determine the
excess return of a stock, other security, or
portfolio over the security's required rate of return
as determined by the Capital Asset Pricing Model.
This model is used to adjust for the level of beta
risk, so that riskier securities are expected to have
higher returns. The measure was first used in the
evaluation of mutual fund managers by Michael
Jensen in the 1970's.

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JENSEN’S ALPHA
To calculate alpha, the following inputs are needed:

the realized return (on the portfolio),

the market return,

the risk-free rate of return, and

the beta of the portfolio.

Jensen's alpha = Portfolio Return - (Risk free return + (Market

Return - Risk free Return) * Beta)

Alpha is still widely used to evaluate mutual fund and portfolio

manager performance, often in conjunction with the Sharpe
ratio and the Treynor ratio.

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Thank You

gaurav@scriptechindia.com

98201 62597

July 12, 2024