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Portfolio Analysis

Portfolio Analysis

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Published by: simambi8268 on Apr 19, 2010
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02/12/2014

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PORTFOLIO ANALYSIS

Introduction
:
The process of investment consists of two major tasks. (i) Security analysis and (ii)Portfolio Management. Security analysis consists of examining the risk -returncharacteristics of individual securities. Security analysis helps in the calculation of intrinsicvalue of a security and identification of overpriced and under priced securities. Portfoliomanagement consists of examining the risk-return characteristics in the portfolio context. Ithelps in the selection of the best possible portfolio from a set of feasible portfolios.Security Return:
Expected rate of return from an individual security ‘A’ is the weighted average of possible outcomes of rates of return, where the weights are the probabilities. If a security isexpected to provide the possible rates of return with the probability of occurrence, as showntable 13.1 expected rate of return
( )
A
can be calculated as follows.Table 13.1
State of the EconomyProbability of OccurrencePossible Rate of Return
(Percent)

Deep recession 0.05 -3.0

2
Mild recession 0.20 6.0Average Economy 0.50 110.Mild Boom 0.20 14.0Strong Boom 0.05 19.0Expected rate of return from security ‘A’ =
A
=
iini
p
1
=

A
=
nn
p p p p
+++++
332211

A
= (-3.0)(0.05) + (6.0)(0.20) + (11.0)(0.50) + (14.0)(0.20) + (19.0)(0.05) = 10.3%Security Risk
) Risk involved in individual securities can be measured by variance or standarddeviation. Risk is present when the estimated distribution has more than one possibleoutcome. In the case security ‘A’, where there are five possible rates of return, risk ispresent.Variance is a measure of the dispersion of possible outcomes around its expectedvalue (Mean). The larger the variance, the greater the dispersion.Variance =
( ) ( ) ( )
n An A A
p p p
22221212
++=
σ
=
( )
i Aini
p
21
=
Variance is the sum of the squared deviations multiplied by the probability of occurrence.
2
σ
= (-3.0 - 10.3)
2
0.05 + (6.0 - 10.3)
2
0.20 + (11 – 10.3)
2
0.50 + (14 – 10.3)
2
0.20+ (19 – 10.3)
2
0.05.= 8.8445 + 3.698 + 0.245 + 2.738 + 3.7845= 19.31%Standard deviation (
σ
) is an alternative measure of dispersion about the mean. Thestandard deviation is found by taking the square root of the variance.Standard deviation =
σ
=
( )
i Aini
p
=
=
12
σ
=
31.19
= 4.39%

3
Portfolio Investment: Individually securities possess risk. The future return expected from a securityvaries and the variability of returns is risk. Rarely we find investors putting all their wealth inone single security. Investors are risk averse. They try to maximise their return given theirisk taking ability or alternatively, investors will try to minimise the risk given their requiredrate of return. Investors follow a financial dictum “NOT TO PUT ALL THE EGGS IN ONEBASKET”. It is believed that if money is invested in several securities simultaneously, theloss in one will be compensated by the gain in others. As a result investors put their moneyin more than one security or a combination of securities, which is known as portfolioinvestment. The group of securities held together as an investment is known as “Portfolio”.The objective of portfolio investment is to spread and minimise risk.The following steps are involved in portfolio management
Portfolio Analysis
Portfolio Selection
Portfolio Revision
Portfolio EvaluationPortfolio Analysis
Investor identifies the securities in which he would like to invest. He estimates therisk-return characteristics of these securities. He develops number of portfolios from thegiven set of securities. For each alternative portfolio investor determines the expected returnand risk. The process of determining the portfolio return and portfolio risk is known asportfolio analysis.Portfolio Return
) Expected return of a portfolio (
) is the weighted average of the expected returns of the individual securities held in a portfolio. The weights are the proportions of moneyinvested in each security out of the total investment. For example, imagine that there arethree securities in a portfolio with the following expected rates of return.
%15
=
A

%20
=
B

%8
=
c
Table 13.2 Alternative Portolios
Proportionof 1 2 3 4 5

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