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Securities Analysis and Portfolio Management
Securities Analysis and Portfolio Management
Part-A: Investment fundamentals Understanding investment Some definitions Sources and types of risk Risk-return trade-off in different types of securities Important considerations in investment process Part-B: Securities Analysis Securities analysis concept and types Framework of fundamental securities analysis Intrinsic valuation & relative valuation Part-C: Portfolio Management Portfolio concept Modern Portfolio Theory: Markowitz Portfolio Theory Determination of optimum portfolio Single-Index model, Multi-Index model Capital Market Theory Portfolio performance measurement
Contents
Part-A
Investment Fundamentals
Understanding investment
Investment is commitment of fund to one or more assets that
is held over some future time period. Investing may be very conservative as well as aggressively speculative. Whatever be the perspective, investment is important to improve future welfare. Funds to be invested may come from assets already owned, borrowed money, savings or foregone consumptions. By forgoing consumption today and investing the savings, investors expect to enhance their future consumption possibilities by increasing their wealth. Investment can be made to intangible assets like marketable securities or to real assets like gold, real estate etc. More generally it refers to investment in financial assets.
Some definitions:
Financial assets: These are pieces of paper (or electronic) evidencing claim on some issuer. Marketable securities: Financial assets that are easily and cheaply traded in organized markets. Portfolio: The securities held by an investor taken as a unit. Expected return: Investors invest with the hope to earn a return by holding the investment over a certain time period. Realized return: The rate of return that is earned after maturity of investment period. Risk: The chance that expected return may not be achieved in reality.
Risk-Free Rate of Return: A return on riskless asset, often proxied by the rate of return on treasury bills. RiskAdverse Investor: An investor who will not assume a given level of risk unless there is an expectation of adequate compensation for having done so. Risk Premium: The additional return beyond risk fee rate that is required for making investment decision in risky assets.
Definitions conti.
Passive Investment Strategy: A strategy that determines initial investment proportions and assets and make few changes over time. Active Investment Strategy: A strategy that seeks to change investment proportions and assets in the belief that profits can be made. Efficient Market Hypothesis(EMH): The proposition that security markets are efficient, in the sense that price of securities reflect their economic value based on price sensitive information.
Weak-form EMH Semi-strong EMH Strong EMH
Definitions Conti.
Face value or Par value or Stated value: The value at which corporation issue its shares in case of common share or the redemption value paid at maturity in case of bond. New stock is usually sold at more than par value, with the difference being recorded on balance sheet as capital in excess of par value. Book Value: The accounting value of equity as shown in the balance sheet. It is the sum of common stock outstanding, capital in excess of par value, and retained earnings. Dividing this sum or total book value by the number of common shares outstanding produces the book value par share. Although it plays an important role in investment decision, market value par share is the critical item of interest to investors.
Broad Types:
Systematic/Market Risk Non-systematic/Non-market/Company-specific Risk
Derivative securities are those that derive their value in whole or in part by having a claim on some underlying value. Options and futures are derivative securities
Options
Expected return Corporate bonds
RF
Part-B
Securities Analysis
involving the valuation and analysis of individual securities. Two basic approaches of security analysis are fundamental analysis and technical analysis. Fundament analysis is the study of stocks value using basic financial variables in order to order to determine companys intrinsic value. The variables are sales, profit margin, depreciation, tax rate, sources of financing, asset utilization and other factors. Additional analysis could involve the companys competitive position in the industry, labor relations, technological changes, management, foreign competition, and so on. Technical analysis is the search for identifiable and recurring stock price patterns. Behavioral Finance Implications: Investors are aware of market efficiency but sometimes overlook the issue of psychology in financial markets- that is, the role that emotions play. Particularly, in short turn, inventors emotions affect stock prices, and markets
It carry investor expectation of above average future growth in earnings and above average valuations as a result of high price/earnings ratios. Investors expect these stocks to perform well in future and they are willing to pay high multiples for this expected growth.
Value Stock: Features cheap assets and strong balance sheets. In many cases, bottom-up investing does not attempt to make a clear distinction between growth and value stocks. Top-down approach is better approach.
Top-down Approach
In this approach
investors begin with economy/market considering interest rates and inflation to find out favorable time to invest in common stock then consider future industry/sector prospect to determine which industry/sector to invest in Finally promising individual companies of interest in the prospective sectors are analyzed for investment decision.
Alternatively, in practice, investors can use DDM to select stocks. The expected rate of return, k, for constant growth stock can be written as k= D1/Po + g, where D1/Po is dividend yield and the 2nd part g is price change component
Relative Valuation
Relative valuation technique uses comparisons to determine a stocks value. By calculating measures such as P/E ratio and making comparisons to some benchmark(s) such as the market, an industry or other stocks history over time, analyst can avoid having to estimate g and k parameters of DDM. In relative valuation, investors use several different ratios such as P/E, P/B, P/S etc in an attempt to assess value of a stock through comparison with benchmark.
P/E ratio simply means the multiples of earnings at which the stock is selling. For example, if a stocks
most recent 12 months earning is Tk 5 and its is selling now at Tk 150, then it is said that the stock is selling for a multiple of 30.
This indicates that P/E depends on: 1. Expected dividend payout ratio, D1/E 2. Required rate of return, k, which is to be estimated 3. Expected growth rate of dividends Thus following relationship should hold, being other things equal: 1. The higher the expected payout ratio, the higher the P/E ratio 2. The higher the expected growth rate, the higher the P/E ratio 3. The higher the required rate of return, the lower the P/E ratio
Then calculate the forward P/E ratio as Forward P/E ratio= Po/E1, where E1 is expected earning for next year In practice, analysts often recommend stocks on the basis of this forward P/E ratio or multiplier by making a relative judgment with some benchmark.
Part-C
Portfolio Management
Risk Diversification- the objective of portfolio formation without affecting the return significantly
Risk Diversification
Risk diversification is the key to the management of portfolio risk, because it allows investors to significantly lower the portfolio risk without adversely affecting return. Diversification types:
Random or naive diversification Efficient diversification
Efficient diversification
Efficient diversification takes place in an efficient portfolio that has the smallest portfolio risk for a given level of expected return or the largest expected return for a given level of risk. Investors can specify a portfolio risk level they are willing to assume and maximize the expected return on the portfolio for this level of risk. Rational investors look for efficient portfolios, because these portfolios are optimized on the two dimensions of most importance to investors- return and risk.
Efficient Frontiers
Graph for the risk-return trade-off according to Markowitz portfolio theory is drawn below.
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 C Global minimum portfolio Risk
E(R)
Markowitz Model for Selection of Optimal Asset Classes-Asset Allocation Decision: Markowitz model is typically thought of in terms of selecting portfolios of individual securities. But alternatively, it can be used as a selection technique for asset classes and asset allocation.
The security responds only to market index movement as residual errors of the securities are uncorrelated. The residual errors occur due to deviations from the fitted relationship between security return and market return. For any period, it represents the difference between the actual return(Ri) and the return predicted by the parameters of the model(iRM)
i2=i2[M2}+ ei2
=Market risk + company-specific risk
This simplification also applies to portfolios, providing an alternative expression to use in finding the minimum variance set of portfolios:
The Single-Index model is an alternative to Markowitz model to determine the efficient frontiers with much fewer calculations, 3n+2 calculations, instead of n(n-1)/2 calculations. For 20 securities, it requires 62 inputs instead of 190 in Markowitz model.
Multi-Index Model
Some researchers have attempted to capture some non-market influences on stock price by constructing Multi-Index model. Probably the most obvious non-market influence is the industry factor. Multi-index model is given by the equation:
E(Ri)=ai+biRM+ciNF + ei, where NF=non-market factor
CMT Graphs:
Borrowing
Market portfolio
M1 E(R) RF M2
M
Return
M
Lending
RF
Risk
CML:
CML(Capital Market Line): A straight line, depicts equilibrium conditions that prevails in the market for efficient portfolios consisting of the optimal portfolio risky assets and the risk-free asset. All combinations of the risk-free asset and risky portfolio M are on CML, and in equilibrium, all investors will end up with portfolios somewhere on the CML. E(RM)
E(R) RF
Risk of market portfolio M, M
E(Rp)=RF+(E(RM)-RF)p/
2
M
Risk
SML:
SML (Security Market Line): It says that the expected rate of return from an asset is function of the two components of the required rate of return- the risk free rate and risk premium, and can be written by, k=RF+(E(RM)-RF). At market portfolio M,
Required rate of return
=1. M
Y
Assets more risky than market portfolio
undervalued X
Assets less risky than market portfolio
Overvalued
RF
M
1
SML..
CAPM formally relates the expected rate of return for any security of portfolio with the relevant risk measure. This is the most cited form of relationship and graphical representation of CAPM.
RF
It measures the excess return per unit of total risk(SDp) of the portfolio The higher the RVAR, the better the portfolio performance Portfolios can be ranked by RVAR and best performing one can be determined Appropriate benchmark is used for relative comparisons in performance measurement
0 RM - RF
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