Securities Analysis

Understanding investment Investment Investment is commitment of fund to one or more assets that is commitment of fund to one or more assets that is held over some future time period.<br><br> is held over some future time period. Investing may be very conservative as well as aggressively Investing may be very conservative as well as aggressively speculative. speculative.<br><br> Whatever be the perspective, investment is important to Whatever be the perspective, investment is important to improve future welfare. improve future welfare. Funds to be invested may come from assets already owned, Funds to be invested may come from assets already owned, borrowed money, savings or foregone consumptions.<br><br> borrowed money, savings or foregone consumptions. By forgoing consumption today and investing the savings, By forgoing consumption today and investing the savings, investors expect to enhance their future consumption investors expect to enhance their future consumption possibilities by increasing their wealth. possibilities by increasing their wealth.<br><br> Investment can be made to intangible assets like marketable Investment can be made to intangible assets like marketable securities or to real assets like gold, real estate etc. More securities or to real assets like gold, real estate etc. More generally it refers to investment in financial assets.<br><br> generally it refers to investment in financial assets. Investments Investments refers to the study of the investment process, refers to the study of the investment process, generally in financial assets like marketable securities to generally in financial assets like marketable securities to maximize investor 9s wealth, which is the sum of investor 9s maximize investor 9s wealth, which is the sum of investor 9s current income and present value of future income. It has current income and present value of future income.<br><br> It has two primary functions: analysis and management. two primary functions: analysis and management. Whether Investments is Arts or Science?<br><br> Whether Investments is Arts or Science? Some definitions: Some definitions: Financial assets: Financial assets: These are pieces of paper (or These are pieces of paper (or electronic) evidencing claim on some issuer. electronic) evidencing claim on some issuer.<br><br> Marketable securities: Marketable securities: Financial assets that are easily and Financial assets that are easily and cheaply traded in organized markets. cheaply traded in organized markets. Portfolio: Portfolio: The securities held by an investor taken as a The securities held by an investor taken as a unit.<br><br> unit. Expected return: Expected return: Investors invest with the hope to earn Investors invest with the hope to earn a return by holding the investment over a certain time a return by holding the investment over a certain time period. period.<br><br> Realized return: Realized return: The rate of return that is earned after The rate of return that is earned after maturity of investment period. maturity of investment period. Risk Risk : : The chance that expected return may not be The chance that expected return may not be achieved in reality.<br><br> achieved in reality. Risk Risk - - Free Rate of Return: Free Rate of Return: A return on A return on riskless riskless asset, asset, often often proxied proxied by the rate of return on treasury bills. by the rate of return on treasury bills.<br><br> Risk Risk 3 3 Adverse Investor: Adverse Investor: An investor who will not assume a An investor who will not assume a given level of risk unless there is an expectation of given level of risk unless there is an expectation of adequate compensation for having done so. adequate compensation for having done so. Risk Premium: Risk Premium: The additional return beyond risk fee rate The additional return beyond risk fee rate that is required for making investment decision in risky that is required for making investment decision in risky assets.<br><br> assets. Definitions Definitions conti conti &. &.<br><br> Passive Investment Strategy: Passive Investment Strategy: A strategy that determines A strategy that determines initial investment proportions and assets and make few initial investment proportions and assets and make few changes over time. changes over time. Active Investment Strategy: Active Investment Strategy: A strategy that seeks to A strategy that seeks to change investment proportions and assets in the belief change investment proportions and assets in the belief that profits can be made.<br><br> that profits can be made. Efficient Market Hypothesis(EMH): Efficient Market Hypothesis(EMH): The proposition that The proposition that security markets are efficient, in the sense that price of security markets are efficient, in the sense that price of securities reflect their economic value based on price securities reflect their economic value based on price sensitive information. sensitive information.<br><br> Weak Weak - - form EMH form EMH Semi Semi - - strong EMH strong EMH Strong EMH Strong EMH Definitions Conti&. Definitions Conti&. Face value or Par value or Stated value: Face value or Par value or Stated value: The value at which The value at which corporation issue its shares in case of common share or corporation issue its shares in case of common share or the redemption value paid at maturity in case of bond.<br><br> the redemption value paid at maturity in case of bond. New stock is usually sold at more than par value, with New stock is usually sold at more than par value, with the difference being recorded on balance sheet as the difference being recorded on balance sheet as ccapital in excess of par value d. ccapital in excess of par value d.<br><br> Book Value: Book Value: The accounting value of equity as shown in The accounting value of equity as shown in the balance sheet. It is the sum of common stock the balance sheet. It is the sum of common stock outstanding, capital in excess of par value, and retained outstanding, capital in excess of par value, and retained earnings.<br><br> Dividing this sum or total book value by the earnings. Dividing this sum or total book value by the number of common shares outstanding produces the number of common shares outstanding produces the book value par share. Although it plays an important book value par share.<br><br> Although it plays an important role in investment decision, market value par share is role in investment decision, market value par share is the critical item of interest to investors. the critical item of interest to investors. Sources and Types of Risk Sources and Types of Risk Sources of Risk: Sources of Risk: Interest rate risk Interest rate risk Market risk Market risk Inflation risk Inflation risk Business risk Business risk Financial risk Financial risk Liquidity risk Liquidity risk Exchange rate risk Exchange rate risk Country risk Country risk Broad Types: Broad Types: Systematic/Market Risk Systematic/Market Risk Non Non - - systematic/Non systematic/Non - - market/Company market/Company - - specific Risk specific Risk Risk Risk - - return trade return trade - - off in different types of securities off in different types of securities Various types of securities: Various types of securities: Equity securities Equity securities may be may be - - Ordinary share or Common share, gives real ownership because hol Ordinary share or Common share, gives real ownership because hol der bears der bears ultimate risk and enjoy return and have voting rights ultimate risk and enjoy return and have voting rights - - Preferential share, enjoy fixed dividend, avoids risk, do not ha Preferential share, enjoy fixed dividend, avoids risk, do not ha ve voting right.<br><br> ve voting right. Debt securities Debt securities may be may be - - Bond, a secured debt instrument, payable on first on liquidity Bond, a secured debt instrument, payable on first on liquidity - - Debenture, an unsecured debt instrument, Debenture, an unsecured debt instrument, Derivative securities Derivative securities are those that derive their value in whole or in are those that derive their value in whole or in part by having a claim on some underlying value. Options and part by having a claim on some underlying value.<br><br> Options and futures are derivative securities futures are derivative securities Corporate bonds Corporate bonds Common stocks Common stocks Options Options Futures Futures RF RF Expected return Expected return Risk Risk Factors Affecting Security Prices Factors Affecting Security Prices Stock splits Stock splits Dividend announcements Dividend announcements Initial public offerings Initial public offerings Reactions to macro and micro economic news Reactions to macro and micro economic news Demand/supply of securities in the market Demand/supply of securities in the market Marketability of securities Marketability of securities Dividend payments Dividend payments Many others Many others Direct investment and indirect Direct investment and indirect investment investment In In Direct Investing Direct Investing , investors buy and sell , investors buy and sell securities themselves, typically through securities themselves, typically through brokerage accounts. Active investors may brokerage accounts. Active investors may prefers this type of investing.<br><br> prefers this type of investing. In In Indirect Investing Indirect Investing , investors buy and sell , investors buy and sell shares of investment companies, which in turn shares of investment companies, which in turn hold portfolios of securities. Individual who hold portfolios of securities.<br><br> Individual who are not active may prefer this type of investing. are not active may prefer this type of investing. Important considerations in investment Important considerations in investment decision process: decision process: Investment decision should be considered based on economy, Investment decision should be considered based on economy, industry consideration and company fundamentals including industry consideration and company fundamentals including management & financial performance management & financial performance Investment decision process can be lengthy and involved Investment decision process can be lengthy and involved The great unknown may exist whatever be the individual actions The great unknown may exist whatever be the individual actions Global investment arena Global investment arena New economy New economy vrs vrs old economy stocks old economy stocks The rise of the internet The rise of the internet - - a true revolution for investment a true revolution for investment information.<br><br> information. Institutional investors Institutional investors vrs vrs individual investor individual investor Risk Risk - - return preference return preference Traditionally, investors have analyzed and managed securities us Traditionally, investors have analyzed and managed securities us ing a ing a broad two broad two - - step process: step process: security analysis and security analysis and portfolio management portfolio management Part Part - - B B Securities Analysis Securities Analysis Security Analysis Concept & Types Security Analysis Concept & Types Security analysis Security analysis is the first part of investment decision process is the first part of investment decision process involving the valuation and analysis of individual securities. T involving the valuation and analysis of individual securities.<br><br> T wo basic wo basic approaches of security analysis are fundamental analysis and tec approaches of security analysis are fundamental analysis and tec hnical hnical analysis. analysis. Fundament analysis Fundament analysis is the study of stocks value using basic is the study of stocks value using basic financial variables in order to order to determine company 9s int financial variables in order to order to determine company 9s int rinsic rinsic value.<br><br> The variables are sales, profit margin, depreciation, tax value. The variables are sales, profit margin, depreciation, tax rate, rate, sources of financing, asset utilization and other factors. Addit sources of financing, asset utilization and other factors.<br><br> Addit ional ional analysis could involve the company 9s competitive position in the analysis could involve the company 9s competitive position in the industry, labor relations, technological changes, management, fo industry, labor relations, technological changes, management, fo reign reign competition, and so on. competition, and so on. Technical analysis Technical analysis is the search for identifiable and recurring stock is the search for identifiable and recurring stock price patterns.<br><br> price patterns. Behavioral Finance Implications: Behavioral Finance Implications: Investors are aware of market Investors are aware of market efficiency but sometimes overlook the issue of psychology in efficiency but sometimes overlook the issue of psychology in financial markets financial markets - - that is, the that is, the role that emotions play role that emotions play . Particularly, .<br><br> Particularly, in short turn, inventors 9 emotions affect stock prices, and mark in short turn, inventors 9 emotions affect stock prices, and mark ets ets Framework for Fundamental Analysis: Framework for Fundamental Analysis: Bottom Bottom - - up approach, up approach, where investors focus directly on a company 9s where investors focus directly on a company 9s basic. Analysis of such information as the company 9s products, i basic. Analysis of such information as the company 9s products, i ts ts competitive position and its financial status leads to an estima competitive position and its financial status leads to an estima te of the te of the company's earnings potential and ultimately its value in the mar company's earnings potential and ultimately its value in the mar ket.<br><br> ket. The The emphasis in this approach is on finding companies with good emphasis in this approach is on finding companies with good growth prospect growth prospect , and making accurate , and making accurate earnings estimates earnings estimates . Thus .<br><br> Thus bottom bottom - - up fundamental research is broken in two categories: up fundamental research is broken in two categories: growth growth investing investing and and value investing value investing Growth Stock: Growth Stock: It carry investor expectation of above average future growth in It carry investor expectation of above average future growth in earnings earnings and above average valuations as a result of high price/earnings and above average valuations as a result of high price/earnings ratios. ratios. Investors expect these stocks to perform well in future and they Investors expect these stocks to perform well in future and they are are willing to pay high multiples for this expected growth.<br><br> willing to pay high multiples for this expected growth. Value Stock: Value Stock: Features cheap assets and strong balance sheets. Features cheap assets and strong balance sheets.<br><br> In many cases, bottom In many cases, bottom - - up investing does not attempt to make a clear distinction up investing does not attempt to make a clear distinction between growth and value stocks. Top between growth and value stocks. Top - - down approach is better approach.<br><br> down approach is better approach. Top Top - - down Approach down Approach In this approach In this approach investors begin with economy/market considering investors begin with economy/market considering interest rates and inflation to find out favorable time to interest rates and inflation to find out favorable time to invest in common stock invest in common stock then consider future industry/sector prospect to then consider future industry/sector prospect to determine which industry/sector to invest in determine which industry/sector to invest in Finally promising individual companies of interest in Finally promising individual companies of interest in the prospective sectors are analyzed for investment the prospective sectors are analyzed for investment decision. decision.<br><br> Fundamental Analysis at Fundamental Analysis at Company Level: Company Level: There are two basic approaches for valuation of There are two basic approaches for valuation of common stocks using fundamental analysis, common stocks using fundamental analysis, which are: which are: Intrinsic Valuation: Intrinsic Valuation: Discounted cash flow(DCF) Discounted cash flow(DCF) technique. One form of DCF is Dividend Discount technique. One form of DCF is Dividend Discount Model(DDM), that uses present value method by Model(DDM), that uses present value method by discounting back all future dividends discounting back all future dividends Relative Valuation Relative Valuation Model, uses P/E ratio, P/B Model, uses P/E ratio, P/B ratio and P/S ratio ratio and P/S ratio Intrinsic Valuation, DDM: Intrinsic Valuation, DDM: In this method, an investor or analyst carefully studies the fut In this method, an investor or analyst carefully studies the fut ure ure prospects for a company and estimates the likely dividends to be prospects for a company and estimates the likely dividends to be paid, paid, which are the only payments an investor receives directly from a which are the only payments an investor receives directly from a company.<br><br> In addition, the analyst estimates an appropriate requi company. In addition, the analyst estimates an appropriate requi red rate red rate of return on the risk foreseen in the dividends. Then calculate of return on the risk foreseen in the dividends.<br><br> Then calculate the the estimated discounted present value of all future dividends as be estimated discounted present value of all future dividends as be low: low: PV of stock, V PV of stock, V o o = D1/(1+k) +D2/(1+k) = D1/(1+k) +D2/(1+k) 2 2 + D3/(1+k) + D3/(1+k) 3 3 +&.. +&.. =D1/(k =D1/(k 3 3 g) && (after simplification) g) && (after simplification) where, D1, D2, D3..are future 1st, 2nd , 3rd years dividends, k where, D1, D2, D3..are future 1st, 2nd , 3rd years dividends, k is required rate of return is required rate of return Now, Now, If Vo > Po, the stock is undervalued and should be purchased If Vo > Po, the stock is undervalued and should be purchased If Vo < Po, the stock is overvalued and should be not be purchas If Vo < Po, the stock is overvalued and should be not be purchas ed ed If Vo = Po, the stock is at correctly priced If Vo = Po, the stock is at correctly priced Alternatively Alternatively , , in practice, investors can use DDM to select stocks in practice, investors can use DDM to select stocks .<br><br> The expected . The expected rate of return, k, for constant growth stock can be written as rate of return, k, for constant growth stock can be written as k= D1/P k= D1/P o o + + g, where D1/P g, where D1/P o o is dividend yield and the 2 is dividend yield and the 2 nd nd part g is price change part g is price change component component Relative Valuation Relative Valuation Relative valuation technique uses comparisons to Relative valuation technique uses comparisons to determine a stock 9s value. By calculating measures such determine a stock 9s value.<br><br> By calculating measures such as P/E ratio and making comparisons to some as P/E ratio and making comparisons to some benchmark(s) such as the market, an industry or other benchmark(s) such as the market, an industry or other stocks history over time, analyst can avoid having to stocks history over time, analyst can avoid having to estimate g and k parameters of DDM. estimate g and k parameters of DDM. In relative valuation, investors use several different In relative valuation, investors use several different ratios such as P/E, P/B, P/S etc in an attempt to ratios such as P/E, P/B, P/S etc in an attempt to assess value of a stock through comparison with assess value of a stock through comparison with benchmark.<br><br> benchmark. Earning Multiplier or P/E Ratio Earning Multiplier or P/E Ratio Model: Model: This model is the best This model is the best - - known and most widely used known and most widely used model for stock valuation. Analysts are more model for stock valuation.<br><br> Analysts are more comfortable taking about earning per share (EPS) and comfortable taking about earning per share (EPS) and P/E ratios, and this is how their reports are worded. P/E ratios, and this is how their reports are worded. P/E ratio simply means the multiples of earnings P/E ratio simply means the multiples of earnings at which the stock is selling at which the stock is selling .<br><br> . For example, if a stock 9s For example, if a stock 9s most recent 12 months earning is most recent 12 months earning is Tk Tk 5 and its is selling 5 and its is selling now at now at Tk Tk 150, then it is said that the stock is selling for 150, then it is said that the stock is selling for a multiple of 30. a multiple of 30.<br><br> Determinants of P/E Ratio: Determinants of P/E Ratio: For a constant growth model of DDM, For a constant growth model of DDM, Price of a stock, P=D1/(k Price of a stock, P=D1/(k - - g) g) Or, P/E=(D1/E)/(k Or, P/E=(D1/E)/(k - - g) g) This indicates that P/E depends on: This indicates that P/E depends on: 1. 1. Expected dividend payout ratio, D1/E Expected dividend payout ratio, D1/E 2.<br><br> 2. Required rate of return, k, which is to be estimated Required rate of return, k, which is to be estimated 3. 3.<br><br> Expected growth rate of dividends Expected growth rate of dividends Thus following relationship should hold, being other things equa Thus following relationship should hold, being other things equa l: l: 1. 1. The higher the expected payout ratio, the higher the P/E ratio The higher the expected payout ratio, the higher the P/E ratio 2.<br><br> 2. The higher the expected growth rate, the higher the P/E ratio The higher the expected growth rate, the higher the P/E ratio 3. 3.<br><br> The higher the required rate of return, the lower the P/E ratio The higher the required rate of return, the lower the P/E ratio Valuation Using P/E Ratio: Valuation Using P/E Ratio: To use the earnings multiplier model for valuation of To use the earnings multiplier model for valuation of a stock, investors a stock, investors must look ahead because valuation is always forward looking. The must look ahead because valuation is always forward looking. The y can y can do this by making a forecast of next year 9s earnings per share E do this by making a forecast of next year 9s earnings per share E 1, 1, assuming a constant growth model, as assuming a constant growth model, as Next years earning per share, E1= Next years earning per share, E1= Eo Eo (1+g) (1+g) where, g=ROE where, g=ROE X X (1 (1 - - Payout ratio) Payout ratio) Then calculate the forward P/E ratio as Then calculate the forward P/E ratio as Forward P/E ratio= Po/E1, where E1 is expected earning for next Forward P/E ratio= Po/E1, where E1 is expected earning for next year year In practice, analysts often recommend stocks on the basis of thi In practice, analysts often recommend stocks on the basis of thi s s forward P/E ratio or multiplier by making a relative judgment wi forward P/E ratio or multiplier by making a relative judgment wi th some th some benchmark.<br><br> benchmark. Other Relative Valuation Ratios: Other Relative Valuation Ratios: Price to Book Value(P/B): Price to Book Value(P/B): This is the ratio of stock This is the ratio of stock price to per share stockholders 9 equity. price to per share stockholders 9 equity.<br><br> Analysts recommend lower P/B stock compared to its Analysts recommend lower P/B stock compared to its own ratio over time, its industry ratio, and the market own ratio over time, its industry ratio, and the market ratio as a whole. ratio as a whole. Price to Sales Ratio(P/S): Price to Sales Ratio(P/S): A company 9s stock price A company 9s stock price divided by its sales per share.<br><br> divided by its sales per share. A PSR 1.0 is average for all companies but it is A PSR 1.0 is average for all companies but it is important to interpret the ratio within industry important to interpret the ratio within industry bounds and its own historical average. bounds and its own historical average.<br><br> Part Part - - C C Portfolio Management Portfolio Management I I f the rates of return on individual securities are dependent onl f the rates of return on individual securities are dependent onl y on y on company company - - specific risks of that company and these returns are specific risks of that company and these returns are statistically independent of other securities 9 returns, then in statistically independent of other securities 9 returns, then in that case, that case, the standard deviation of return of the portfolio (formed by n the standard deviation of return of the portfolio (formed by n number of securities) is given by number of securities) is given by à à i i à à p p = = ------------ ------------ (1) (1) a n a n Risk Diversification Risk Diversification - - the objective of portfolio formation the objective of portfolio formation without affecting the return significantly without affecting the return significantly Standard deviation of portfolio return No. of securities Systematic risk Systematic risk Company Company - - specific specific risk risk Total risk Total risk Risk Diversification Risk Diversification Risk diversification is the key to the Risk diversification is the key to the management of portfolio risk, because it allows management of portfolio risk, because it allows investors to significantly lower the portfolio risk investors to significantly lower the portfolio risk without adversely affecting return. without adversely affecting return.<br><br> Diversification types: Diversification types: Random or naive diversification Random or naive diversification Efficient diversification Efficient diversification Random or naive diversification Random or naive diversification : : It refers to the act of randomly diversifying It refers to the act of randomly diversifying without regard to relevant investment characteristics such without regard to relevant investment characteristics such as expected return and industry classification as expected return and industry classification . An . An investor simply selects relatively large number investor simply selects relatively large number of securities randomly.<br><br> of securities randomly. Unfortunately, in such case, the benefits of Unfortunately, in such case, the benefits of random diversification do not continue as we random diversification do not continue as we add more securities, the reduction becomes add more securities, the reduction becomes smaller and smaller. smaller and smaller.<br><br> Efficient diversification Efficient diversification Efficient diversification Efficient diversification takes place in an efficient takes place in an efficient portfolio that has the smallest portfolio risk for a given portfolio that has the smallest portfolio risk for a given level of expected return or the largest expected return level of expected return or the largest expected return for a given level of risk. Investors can specify a portfolio for a given level of risk. Investors can specify a portfolio risk level they are willing to assume and maximize the risk level they are willing to assume and maximize the expected return on the portfolio for this level of risk.<br><br> expected return on the portfolio for this level of risk. Rational investors Rational investors look for efficient portfolios, because look for efficient portfolios, because these portfolios are optimized on the two dimensions of these portfolios are optimized on the two dimensions of most importance to investors most importance to investors - - return and risk. return and risk.<br><br> Modern Portfolio Theory Modern Portfolio Theory In 1952, In 1952, Markowitz Markowitz , the father of modern portfolio theory, developed , the father of modern portfolio theory, developed the basic principle of portfolio diversification in a formal w the basic principle of portfolio diversification in a formal w ay, in ay, in quantified form, that shows why and how portfolio diversificatio quantified form, that shows why and how portfolio diversificatio n works n works to reduce the risk of a portfolio to an investor. to reduce the risk of a portfolio to an investor. Modern Portfolio Modern Portfolio theory hypothesizes how investors should behave theory hypothesizes how investors should behave .<br><br> . According to According to Markowitz Markowitz , the portfolio risk is not simply a weighted , the portfolio risk is not simply a weighted average of the risks brought by individual securities in the por average of the risks brought by individual securities in the por tfolio but tfolio but it also includes the risks that occurs due to correlations among it also includes the risks that occurs due to correlations among the the securities in the portfolio. As the no.<br><br> of securities in the por securities in the portfolio. As the no. of securities in the por tfolio tfolio increases, contribution of individual security 9s risk decreases increases, contribution of individual security 9s risk decreases due to due to offsetting effect of strong performing and poor performing secur offsetting effect of strong performing and poor performing secur ities in ities in the portfolio and the importance of covariance relationships amo the portfolio and the importance of covariance relationships amo ng ng securities increases.<br><br> Thus the portfolio risk is given by securities increases. Thus the portfolio risk is given by à à 2 2 p p = 1 w = 1 w i i 2 2 à à i i 2 2 + 1 1 + 1 1 w w i i w w j j Á Á ij ij à à i i à à j j = 1 1 = 1 1 w w i i w w j j Á Á ij ij à à i i à à j j (the 1 (the 1 st st term is neglected for large n) term is neglected for large n) Efficient Frontiers Efficient Frontiers Risk à E ( R ) A Global minimum portfolio C B Portfolio on AB section are better than those on AC in risk-return perspective and so portfolios on AB are called efficient portfolios that offers best risk-return combinations to investors Graph for the risk Graph for the risk - - return trade return trade - - off according to off according to Markowitz Markowitz portfolio theory is portfolio theory is drawn below. drawn below.<br><br> Computing Problem with Original Computing Problem with Original Markowitz Markowitz Theory, and Later Simplification Theory, and Later Simplification As n increases, n(n As n increases, n(n - - 1) 1) covariances covariances (inputs) are required (inputs) are required to calculate under to calculate under Markowitz Markowitz model. Due to this model. Due to this complexity of computation, it was mainly used for complexity of computation, it was mainly used for academic purposes before simplification.<br><br> academic purposes before simplification. It was observed that mirror images of It was observed that mirror images of covariances covariances were were present in present in Markowitz 9s Markowitz 9s model. So after excluding the model.<br><br> So after excluding the mirror images in the simplified form, n(n mirror images in the simplified form, n(n - - 1)/2 unique 1)/2 unique covariances covariances are required for using this model and since are required for using this model and since then it is being used by investors. then it is being used by investors. Markowitz Markowitz Model for Selection of Optimal Model for Selection of Optimal Asset Classes Asset Classes - - Asset Allocation Decision: Asset Allocation Decision: Markowitz Markowitz model is typically thought of in terms model is typically thought of in terms of selecting portfolios of individual securities.<br><br> But of selecting portfolios of individual securities. But alternatively, it can be used as a selection alternatively, it can be used as a selection technique for asset classes and asset allocation. technique for asset classes and asset allocation.<br><br> Single Index Model Single Index Model - - An Alternative An Alternative Simplified Approach to Determine Simplified Approach to Determine Efficient Frontiers Efficient Frontiers Single Single - - Index model assumes that the risk of return from each Index model assumes that the risk of return from each security has two components security has two components - - the market related component( the market related component( ² iR ² iR M M )caused by macro events and )caused by macro events and the company the company - - specific component( specific component( ei ei ) which is a random residual ) which is a random residual error caused by micro events. error caused by micro events. The security responds only to market index movement as The security responds only to market index movement as residual errors of the securities are uncorrelated.<br><br> The residu residual errors of the securities are uncorrelated. The residu al al errors occur due to deviations from the fitted relationship errors occur due to deviations from the fitted relationship between security return and market return. For any period, it between security return and market return.<br><br> For any period, it represents the difference between the actual return( represents the difference between the actual return( Ri Ri ) and the ) and the return predicted by the parameters of the model( return predicted by the parameters of the model( ² iR ² iR M M ) ) The Single Index model is given by the equation: The Single Index model is given by the equation: Ri Ri = = ± i ± i + + ² iR ² iR M M + + ei ei &&&for security i, where &&&for security i, where Ri Ri = the return on security = the return on security R R M M =the return from the market index =the return from the market index ± i ± i =risk free part of security =risk free part of security i 9s i 9s return which is independent return which is independent of market return of market return ² i ² i =sensitivity of security i, a measure of change of =sensitivity of security i, a measure of change of Ri Ri for per for per unit change R unit change R M, M, which is a constant which is a constant ei ei =random residual error, which is company specific =random residual error, which is company specific ei R M Ri Single Index Model Diagram ² i ± ± i i Single Index Model&& Single Index Model&& Total risk of a security , as measured by its variance, consists Total risk of a security , as measured by its variance, consists of of two components: market risk and unique risk and given by two components: market risk and unique risk and given by ± ± i i 2 2 = ² i = ² i 2 2 [ [ ± ± M M 2 2 }+ }+ ± ± ei ei 2 2 =Market risk + company =Market risk + company - - specific risk specific risk This simplification also applies to portfolios, providing an This simplification also applies to portfolios, providing an alternative expression to use in finding the minimum variance se alternative expression to use in finding the minimum variance se t t of portfolios: of portfolios: ± ± p p 2 2 = ² = ² p p 2 2 [ [ ± ± M M 2 2 }+ }+ ± ± ep ep 2 2 The Single The Single - - Index model is an alternative to Index model is an alternative to Markowitz Markowitz model to model to determine the efficient frontiers with much fewer calculations, determine the efficient frontiers with much fewer calculations, 3n+2 calculations, instead of n(n 3n+2 calculations, instead of n(n - - 1)/2 calculations. For 20 1)/2 calculations. For 20 securities, it requires 62 inputs instead of 190 in securities, it requires 62 inputs instead of 190 in Markowitz Markowitz model.<br><br> model. Multi Multi - - Index Model Index Model Some researchers have attempted to capture some Some researchers have attempted to capture some non non - - market influences on stock price by market influences on stock price by constructing Multi constructing Multi - - Index model. Probably the most Index model.<br><br> Probably the most obvious non obvious non - - market influence is the industry market influence is the industry factor. Multi factor. Multi - - index model is given by the equation: index model is given by the equation: E( E( R R i i )= )= a a i i + + b b i i R R M M + + c c i i NF NF + + e e i i , where NF=non , where NF=non - - market factor market factor Capital Market Theory(CMT) Capital Market heory(CM ) Capital market theory hypothesizes how investors behave rather t Capital market theory hypothesizes how investors behave rather t han how they han how they should behave as in should behave as in Markowitz Markowitz portfolio theory.<br><br> CMT is based on portfolio theory. CMT is based on Markowitz Markowitz theory and but it is an extension of that. theory and but it is an extension of that.<br><br> The more the risk is involved in an investment, the more the ret The more the risk is involved in an investment, the more the ret urn is required urn is required to motivate the investors to motivate the investors . It plays a central role in asset pricing, because it is the ri . It plays a central role in asset pricing, because it is the ri sk sk that investors undertake with expectation to be rewarded.<br><br> that investors undertake with expectation to be rewarded. CMT is build on CMT is build on Markowitz Markowitz Portfolio theory and extended with introduction of Portfolio theory and extended with introduction of risk risk - - free asset that allows investors borrowing and lending at risk free asset that allows investors borrowing and lending at risk - - free rate and free rate and at this, the efficient frontier is completely changed, which in at this, the efficient frontier is completely changed, which in tern leads to a tern leads to a general theory for pricing asset under uncertainty general theory for pricing asset under uncertainty . Borrowing additional ingestible .<br><br> Borrowing additional ingestible fund and investing together with investor 9s wealth allows invest fund and investing together with investor 9s wealth allows invest ors to seek higher ors to seek higher expected return, while assuming greater risk. Likewise, lending expected return, while assuming greater risk. Likewise, lending part of investor 9s wealth part of investor 9s wealth at risk at risk - - free rate, investors can reduce risk at the expense of reduced e free rate, investors can reduce risk at the expense of reduced e xpected return.<br><br> xpected return. CMT Graphs: CMT Graphs: RF M M M M1 M1 M2 M2 RF RF E(R) E(R) à à Risk Risk Return Return Borrowing Borrowing Lending Lending Market portfolio Market portfolio CAPM and Its Two Specifications: CAPM and Its Two Specifications: CML, SML CML, SML CAPM(Capital Asset Pricing Model) CAPM(Capital Asset Pricing Model) This is a form of CMT, and it is an equilibrium This is a form of CMT, and it is an equilibrium model, allows us to measure the relevant risk of an model, allows us to measure the relevant risk of an individual security as well as to assess the relationship individual security as well as to assess the relationship between risk and the returns expected from investing. between risk and the returns expected from investing.<br><br> It has two specifications: CML & SML It has two specifications: CML & SML CML: CML: CML(Capital Market Line): CML(Capital Market Line): A straight line, depicts equilibrium A straight line, depicts equilibrium conditions that prevails in the market for efficient portfolios conditions that prevails in the market for efficient portfolios consisting consisting of the optimal portfolio risky assets and the risk of the optimal portfolio risky assets and the risk - - free asset. All free asset. All combinations of the risk combinations of the risk - - free asset and risky portfolio M are on CML, free asset and risky portfolio M are on CML, and in equilibrium, all investors will end up with portfolios so and in equilibrium, all investors will end up with portfolios so mewhere mewhere on the CML.<br><br> on the CML. Risk of market Risk of market portfolio M, portfolio M, à à M M RF RF Risk Risk E(R) E(R) M M Risk premium for market portfolio Risk premium for market portfolio E(R E(R M M ) ) E( E( Rp Rp )=RF+(E(R )=RF+(E(R M M ) ) - - RF) RF) Á Á p p / / à à M M 2 2 SML: SML: SML (Security Market Line): SML (Security Market Line): It says that the expected rate of return from an It says that the expected rate of return from an asset is function of the two components of the required rate of asset is function of the two components of the required rate of return return - - the risk the risk free rate and risk premium, and can be written by, k=RF+ free rate and risk premium, and can be written by, k=RF+ ² ² (E(R (E(R M M ) ) - - RF). At RF).<br><br> At market portfolio M, market portfolio M, ² ² =1. =1. Required rate of return Required rate of return M M 1 1 RF RF ² ² ² ² M M Assets less risky Assets less risky than market portfolio than market portfolio Assets more risky Assets more risky than market portfolio than market portfolio X X Y Y Overvalued Overvalued undervalued undervalued SML&..<br><br> SML&.. CAPM formally relates the expected rate of return for any CAPM formally relates the expected rate of return for any security of portfolio with the relevant risk measure. This is security of portfolio with the relevant risk measure.<br><br> This is the most cited form of relationship and graphical the most cited form of relationship and graphical representation of CAPM. representation of CAPM. Beta Beta is the change in risk on an individual security is the change in risk on an individual security influenced by 1 percent change in market portfolio return.<br><br> influenced by 1 percent change in market portfolio return. Beta is the relevant measure of risk that can not be Beta is the relevant measure of risk that can not be diversified away in a portfolio of securities and, as such, is diversified away in a portfolio of securities and, as such, is the measure that investors should consider in their portfolio the measure that investors should consider in their portfolio management decision process. management decision process.<br><br> Portfolio Performance Portfolio Performance Measurement Measurement Sharpe 9s measure(Reward to Variability Ratio, RVAR): Sharpe 9s measure(Reward to Variability Ratio, RVAR): The performance of portfolio is calculated in Sharpe 9s measure a The performance of portfolio is calculated in Sharpe 9s measure a s the s the ratio of excess portfolio return to the standard deviation of re ratio of excess portfolio return to the standard deviation of re turn for turn for the portfolio. the portfolio. RVAR=( RVAR=( TRp TRp 3 3 RF)/ RF)/ SDp SDp Note about RVAR: Note about RVAR: It measures the excess return per unit of total risk( It measures the excess return per unit of total risk( SDp SDp ) of the portfolio ) of the portfolio The higher the RVAR, the better the portfolio performance The higher the RVAR, the better the portfolio performance Portfolios can be ranked by RVAR and best performing one can be Portfolios can be ranked by RVAR and best performing one can be determined determined Appropriate benchmark is used for relative comparisons in perfor Appropriate benchmark is used for relative comparisons in perfor mance measurement mance measurement CML of CML of appropriate appropriate benchmarks benchmarks X X Y Y Z Z SDp SDp Rate of return Rate of return RF RF Efficient portfolios lie on CML Efficient portfolios lie on CML Outperformers Outperformers lie above CML lie above CML Underperformers lie under CML Underperformers lie under CML Portfolio Performance Portfolio Performance Measurement&&&& Measurement&&&& Treynor 9s Treynor 9s measure(Reward to Volatility Ratio, RVOR) measure(Reward to Volatility Ratio, RVOR) The performance of portfolio is calculated in The performance of portfolio is calculated in Treynor 9s Treynor 9s measure as the ratio of measure as the ratio of excess portfolio return to the beta of the portfolio which is sy excess portfolio return to the beta of the portfolio which is sy stematic risk.<br><br> stematic risk. RVOR=( RVOR=( TRp TRp 3 3 RF)/ RF)/ ² p ² p Note about RVOL: Note about RVOL: It measures the excess return per unit of systematic risk ( It measures the excess return per unit of systematic risk ( ² p ² p ) of the portfolio ) of the portfolio The higher the RVOR, the better the portfolio performance The higher the RVOR, the better the portfolio performance Portfolios can be ranked by RVOR and best performing one can be Portfolios can be ranked by RVOR and best performing one can be determined determined Rate of return Rate of return RF RF SML of SML of appropriate appropriate benchmarks benchmarks X X Y Y Z Z ² p ² p Efficient portfolios lie on SML Efficient portfolios lie on SML Outperformers Outperformers lie above SML lie above SML Underperformers lie under SML Underperformers lie under SML Portfolio Performance Portfolio Performance Measurement&&&& Measurement&&&& Jensen 9s Differential Return Measure Jensen 9s Differential Return Measure , ± : , ± : It is calculated as the difference between what the It is calculated as the difference between what the portfolio actually earned and what it was expected portfolio actually earned and what it was expected to earn given the portfolio 9s level of systematic risk. to earn given the portfolio 9s level of systematic risk.<br><br> ± ± p p =( =( Rp Rp 3 3 RF) RF) 3 3 [ [ ² p ² p (R (R M M 3 3 RF)] RF)] =Actual return =Actual return 3 3 required return required return R R M M - - RF RF Rp Rp - - RF RF 0 0 X X Y Y Z Z Portfolio monitoring and Portfolio monitoring and rebalancing rebalancing It is important to monitor market conditions, It is important to monitor market conditions, relative asset mix and investors 9 circumstances. relative asset mix and investors 9 circumstances. These changes dynamically and frequently and These changes dynamically and frequently and so there is need for rebalancing the portfolio so there is need for rebalancing the portfolio towards optimal point.<br><br> towards optimal point. Thank You Thank You

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