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Submitted in partial fulfilment of the course Investment Management Submitted To: Prof. K.N.Badhani

Harry Markowitz

A Nobel Memorial Prize winning economist who devised the modern portfolio theory in 1952 studying the effects of asset risk, return, correlation and diversification on probable investment portfolio returns. Markowitz's theories emphasized the importance of portfolios, risk, the correlations between securities and diversification. His work changed the way that people invested. Prior to Markowitz's theories, emphasis was placed on picking single high-yield stocks without any regard to their effects on portfolios as a whole. Markowitz's portfolio theory would be a large stepping stone towards the creation of the capital asset pricing model. To start lets define some basic terms:

Portfolio:

A grouping of financial assets such as stocks, bonds and cash equivalents, as well as their mutual, exchange-traded and closed-fund counterparts. Portfolios are held directly by investors and/or managed by financial professionals. Here we are focussing on portfolio comprising of stocks only.

Risk:

The chance that an investment's actual return will be different than expected. Risk includes the possibility of losing some or all of the original investment. Different versions of risk are usually measured by calculating the standard deviation of the historical returns or average returns of a specific investment A fundamental idea in finance is the relationship between risk and return. The greater the amount of risk that an investor is willing to take on, the greater the potential return. The reason for this is that investors need to be compensated for taking on additional risk.

Correlation:

A statistical measure of how two securities move in relation to each other. Correlations are used in advanced portfolio management. Correlation is computed into what is known as the correlation coefficient, which ranges between -1 and +1. Perfect positive correlation (a correlation co-efficient of +1) implies that as one security moves, either up or down, the other security will move in lockstep, in the same direction and vice versa.

Diversification:

A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio. Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated. Investing in more securities will still yield further diversification benefits, albeit at a drastically smaller rate. Further diversification benefits can be gained by investing in foreign securities because they tend be less closely correlated with domestic investments.

A theory on how risk-averse investors can construct portfolios to optimize or maximize expected return based on a given level of market risk, emphasizing that risk is an inherent part of higher reward. According to the theory, it's possible to construct an "efficient frontier" of optimal portfolios offering the maximum possible expected return for a given level of risk.

Modern portfolio theory states that an investor may choose to exchange risk for return along a curve known as the efficient frontier. Since it is inefficient to incur a given level of risk when one can rearrange the portfolio to achieve a greater expected return for the same risk, there is a strong motivation to optimize.

1) I have taken 14 stocks from NSE 100.All the stocks selected are from different sectors. I have selected four extra stocks because the sector in which the company operate is crucial for the economy. Share prices of all the stocks for the past 10 year (Aug 2002-Aug 2012) on monthly basis have been used as input to the model 2) Based on share price monthly return has been calculated and average of monthly return over the past 10 years would be taken as expected return from the stock. Also we calculate the benefit or diversification via calculating the reduction in risk (standard deviation).As standard deviation for two stock x and y with weight a and b in portfolio i.e. (b=1-a) and standard deviation

and

xy

= (a + b + 2ab )

x y x y xy

p increases as xy increase

3) Since the selected stocks are from different sector correlation between the stocks is expected to be less. This also benefits the investor by diversification. The correlation coefficient as expected is low. The highest correlation with significant t value is between HDFC Bank and LIC housing finance. Although the sector is different but the factors affecting their returns are same thus the two shares move in tandem. 4) After finding out the correlation we find out the covariance coefficient. This is calculated via excel but we can also calculate covariance via method. Correlation of asset is return & js return with regression coefficient deviation

ij

and standard

and

:

j

= Cov(r , r ) / ( )

ij i j i j

5) The expected return of a security in a portfolio is product of weight age of money invested in security and expected return from the security. Total return from portfolio would be sum of all these products. Also we calculate the covariance from the entire portfolio via constructing a covariance matrix. The numbers in this matrix is product of weight of two security and covariance between them. Sum of the values in covariance is the total variance of matrix and correspondingly we find the standard deviation 6) Finally we take two scenarios: i) Short selling is allowed ii) Short selling is not allowed (no negative value in weights of security) Based on this we run the solver with a pre decided return and aim of minimising the variance corresponding to return via changing the weights of security. The global minimum variance portfolio is at a return of 1.96 and risk of 4.7524% and weightage division as follows

-0.048886413, -3% -0.066465098, -4% 0.019117424, 1% -0.033997482, -2% -0.050097663, -3% 0.120915892, 7%

Weightage

Weightage ACC Ashok Leyland Asian Paints Bharti Airtel 0.43351657, 26% Cipla Dabur India GAIL HDFC Bank

0.123028399, 7%

0.160898459, 10%

However when short selling is not allowed global minimum variance portfolio is at return of 1.90% with risk of 5.12%.The weight age of each security is as below

Weightage

0.132453154 0.004096986 0 0.028492797 ACC Ashok Leyland Asian Paints Bharti Airtel Cipla Dabur India GAIL HDFC Bank Infosys

0.107438986 0.185258693

0.413263542

0.128995843

Thus when short selling is not allowed we have result as only six out of fourteen investments are beneficial.

A capital market line is constructed to determine the market portfolio. It is constructed via following steps: 1) The monthly risk free interest rate. The average annual interest rate for last 10 years is 8% thus monthly rate is 0.67% 2) We determine Sharpe ratio as excess of market portfolio over risk free rate divided by risk. Thus Sharpe ratio is reward to volatility ratio 3) With the help of solver we determine maximum Sharpe ratio by changing weight of security and indirectly changing return and standard deviation 4) After getting two points i.e. risk free rate with zero risk and return as 0.67% and point obtained via solver construct line joining the two. This is the Capital Market Line

Capital Market line shows the risk aversion of the investor. Point which lies on right of market portfolio is risk lovers and they borrow money from market at risk free rate and invest in stock market. Thus they are generating high return at risk of higher leverage. Similarly for investors on left of market portfolio are lenders and are investing in risk free securities.

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