You are on page 1of 27

Lecture Notes on

Investments: A Holistic Approach for the Indian



Vijaya B Marisetty
Indian Institute of Finance



Why another attempt?
1. The most popular text books on SAPM or investments in India are written predominantly
by US authors for keeping US students in mind. Many issues are either different in India
or not relevant for the Indian student.
Some of the important differences:

The level of efficiency of Indian market is different from US;
Trading mechanism used in India are different US;
Indian firms are organised differently (business groups) compared to the US firms.
Indian investor profile is quite different from that of US.
Lot of institutional issues (like Indian IPO market mechanism) and products (like
single stock futures) are unique to Indian setting.

2. The Indian authored books are either outdated or superficial in their treatment.
3. None of the Indian books are outcomes of rigorous research conducted by the authors.
What is unique in these lecture notes?
1. The author has spent five years conducting research on Indian markets. He has published
several papers on Indian securities market in highly reputed finance journals (including
Journal of Banking and Finance and Journal of Financial Markets). Hence, all the topics
will have lot of research components based on Indian market.
2. The author spent 2 months with Indian fund managers (during October to November
2009) to understand what topics and content needs to be incorporated for gaining
practical knowledge on Indian funds management industry. Hence, the topics are
designed after due consultation with the practitioners.
3. Efforts are taken to improve the standard of the learning outcomes of the students.
Ultimate aim of this book: I feel that there should be no difference between learning and
practice in an applied area like investments. Hence, the ultimate aim of this book is to make sure
students have smooth transition from the academic world to the real world. There should be
minimum surprises in their future investment management practice.



1.1 What are Investments?
1.2 What is Require rate of return
1.3 What are interest rates?
1.4 The definitions and characteristics and risk and return
Appendix: Introduction to financial maths
2.1 Investment management profession across the world
2.2 Investment management profession in India
2.3 Professional codes of conduct (ethics and penalties)
2.4 The investment management process
Appendix: Interviews with investment managers in India
3.1 Individual versus Institutional investors
3.2 Understanding investor needs
3.3 Preparation of investment policy statement
3.4 How to measure investor’s degree of risk aversion?
3.5 How to ascertain asset allocation mix based on investor’s risk profile?
3.6 Is average Indian investor same as an average US investor?
3.7 What is the role of culture and demographics on investor’s asset allocation mix?
Appendix1: Case studies on investment policy statement
Appendix2: Questionnaire to measure degree of investor’s risk aversion
4.1 Measuring portfolio risk and return
4.2 Measuring correlation and covariance of portfolios

4.3 Understanding the role of covariance on portfolio risk
4.4 How to construct optimal portfolios?
4.5 The limits of diversification benefits
Appendix 1: Derivation of optimal portfolio
Appendix2: Datasets and methodology for creating efficient portfolios in excel
5.1 What happens when a risk free security is added to a risky portfolio?
5.2 What is the tangency portfolio?
5.3 How to derive expected return of a risky security in the market portfolio (CAPM)?
5.4 Does CAPM hold in the real world?
5.5 Alternatives to CAPM: APT and Fama- French Models
6.1 The Efficient Market Hypothesis (EMH)
6.2 Real world versus EMH
6.3 Limits of arbitrage
6.4 Behavioural finance
7.1.1 Fundamental Analysis
7.1.2 Technical Analysis
7.2.1 Types of fixed income securities
7.2.2 Valuation of fixed income securities

7.2.3 Use of Derivatives and fixed income securities in portfolio construction and management
8.1 How to trade in IPOs?
8.2 How to trade in mutual funds?
8.3 How to trade in equities in secondary market
8.4 How to trade in derivatives
8.5 Market microstructure and execution costs
8.6 Algorithmic trading rules
9.1 The framework for performance evaluation of portfolios
9.2 Static measure of performance (Sharp, Jensen, Treynor, Henriksson – Merton, Fama, MM
Square measures)
9.3 Dynamic measures of performance (conditional Jensen, conditional Henriksson- Merton,
Nonlinear Dual Beta measures)


1.1 What are investments?
Investment can be defined as forgoing current consumption for higher future consumption. This
indirectly means that you are letting others to consume your resources with a promise that they
will facilitate your future consumption needs. Such promises can be made through legally
enforceable contracts called securities. Investments can be real or just financial contracts. For
example, purchase of machinery by a firm is a real asset and funding the purchase of the
machinery by subscribing to the firm’s equity issue is a financial contract. Financial assets allow
firms to purchase real assets and the firm in turn distributes wealth generated (by utilising real
assets) to the investors/ purchasers of financial assets. In other words, investors let the firm, in
this case, to consume their resources with a promise that the firm will facilitate investors to
consume in the future.
By using the above definition, investment has three dimensions namely, duration of investment
(time), purchasing power of the future promised value (inflation), and uncertainty of consuming
in the future (firm may or may not facilitate investors’ future consumption: risk). Hence,
investor expects higher return (than their invested amount) to compensate for (1) the duration of
the investment + (2)plus amount lost due to reduction of purchasing power (inflation) during the
investment horizon + (3) risk of a given investment.
Investors are broadly classified as individual investors and institutional investors. Individual
investors generally are salaried and retail business owners and their investments are sourced
mainly from their savings. The popular institutional investors are mutual funds (professionally
managed pooled investment of individuals), insurance firms, pension funds, banks, corporate
entities, private equity firms, and hedge funds. Popular investments are shares (equity), fixed –
income securities, options, futures, commodities, real estate, money market securities, and art
and antiques.
Functions of financial investments in the broader economy:
Economic development is normally measured by the value of its real assets. Real assets include
assets such as, plant machinery, human resources, and natural resources. However, financial
assets act as the medium to transfer, creation, valuation of these real assets. Financial assets
perform three main functions in the broader economy:
1. Efficient allocation of economic resources: Economic growth is a function of the value of
a given economy’s real assets. In other words, those economies that allocate their
resources in projects that have high growth opportunities benefit from higher returns
(higher productivity). Financial assets can facilitate the required resource allocation
process. If the real assets are acquired by issuing shares (financial assets) then financial
markets facilitate smoother and efficient allocation process. Investors can transfer
resources by selling shares of over invested projects and buying shares of under invested

2. Efficient allocation of individual resources: Investors can also improve the efficiency of
their own resource allocation over time. By investing investors can transfer un- utilised
resources to the period of their proper utilisation and thus derive optimal utility.
3. Efficient allocation of risk: The inherent risk of real assets can be decomposed through
financial assets. For example, a firm can issue shares and bonds on the same real assets.
However, it can sell them to different investors based on the risk preferences of the
investors. This allows firms to make investments for a broader spectrum of investors and
hence can make more investments.
2.1 What is Required Rate of Return?
Given that return is a future outcome, uncertainty (risk) is inherent in return. Even the guaranteed
by a fixed deposit issued by a bank has risk in terms of its real value (due to inflation).
Hence, return always depends on the risk of a given investment. And return is positively
Rico Auto
loss of 25%
the daily
Hence, require
rate of return of an investment, after compensating for
the time horizon of the investment, is purely proportional to the risk involved in a given
Standard, October
2009.can be defined as a return that compensates for the time value
of money and extra premium that is proportional to the risk of the investment.
Troubled component manufacturer Rico Auto Industries, facing labour unrest since October 18, has
common forms of risk that can cause uncertainty are as follows:
reported a daily production loss of about 25 per cent at its Gurgaon plant, “due to the unrest caused
by a group of 16 employees”.

1. Business risk: Risk that arises due to firm specific operations related uncertainties.
“We have an excellent rapport with our OEM (original equipment manufacturer) clients and they
know us for our quality of products and our adherence to delivery schedules. There could be a
temporary loss in our business moving to our competitors due this unrest,” Vice-President (HR)
Surendra Chaudhury said. Rico Auto has two manufacturing plants located in Gurgaon and
Dharuhera. Industry executives estimate the monthly turnover from these two factories at around
Rs 80 crore. Since October 20, the company has been unable to operate its Gurgaon plant at full
capacity. A segment of its employees have been working inside the factory under police protection
and have been unable to leave the premises for the last few days. This is because workers who
enter or leave the factory have been assaulted by the striking workers.

“So far, we have managed to bring 500 workers into the factory,” Chaudhury said. While the Gurgaon plant
continues to face unrest, the Dharuhera plant faces no labour problems. The company supplies auto parts to
Hero Honda, Maruti Suzuki, Tata Motors and General Motors.As part of the negotiations between the company
and the trade union, Chaudhury said out of the 16 workers who were dismissed last week, three workers may be
taken back.“Charges against the 16 employees were brought by the company on grounds of indiscipline and
issuing threats to line managers. So the law will take its course 7
and we will act then,” Chaudhury said.

2. Financial risk: Risk that arise due to uncertainty of the firm to pay the borrowed funds.
Economic times 23 Dec 2008.
Fitch Ratings on Tuesday downgraded realty major Unitech Limited's (Unitech) Long-term rating to 'BBB(ind)' from
'A-(ind)' (A minus) and maintains its negative long-term rating outlook. The downgrade reflects the ongoing delay in
the completion of asset sales, and its impact on Unitech's ability to service its short-term debt obligation, according to
Fitch on 11 November 2008 had said that it expected the asset sales to be completed by December 2008, and noted
that the unsuccessful completion of the projected asset sales would trigger a ratings downgrade. The Negative
Outlook reflects Unitech's reduced liquidity position, as the company is facing significant maturities during the next
six months (principal amount around INR27bn) and the ensuing substantial refinancing risk. The liquidity risks are
accentuated by the tightness of the credit environment. The Outlook also reflects potential further negative pressure
on cash flow generation and credit metrics, stemming from a more adverse real estate sector environment than
Following this rating action, Fitch also downgraded single certain structured products loan sell down transactions
where the ratings of the pass through certificates (PTCs). The downgrade of the PTCs follows the downgrade of
Unitech Limited's National Long-term and Short-term ratings to 'BBB (ind)' from 'A-(ind)' (A minus(ind)) and to
'F3(ind)' from 'F2+(ind)', respectively.
Down grading effect on Unitech Ltd Stock Returns









Illiquid stocks back in the ring
Economic Times. 7 Mar 2009
As worsening global and domestic macro conditions prompt more investors to tighten their purse strings, the number of illiquid
stocks is
rapidly on the rise. At latest count, there were around 2,000 such stocks.
3. Liquidity
due to
of than
stocks are thoserisk:
where the
a significant
cost; ie,level
he mayuncertainty
end up paying more
the market
price stocks
while buying
the shares, and receiving less than market rates while selling the shares. On the other hand, it is possible to buy or sell
the firm.
huge quantities of liquid stocks, for a price very close, if not at the market rate. Stock exchanges prepare the list of illiquid stocks in
consultation with Sebi, and advise clients to be cautious while dealing in these stocks. This is because prices of illiquid stocks are
easily manipulated by operators. For a small sum, these operators inflate the stock price, through trading among themselves, and
then unload the stock on retail investors who are drawn to these counters because of the surge in price and volumes. Yet, brokers say
as long as the companies’ fundamentals are sound, one should not worry about the liquidity in these stocks. One of the time tested
axioms of the stock market is that liquidity follows fundamentals and not the other way round. “If the company has strong cash
flows and a good revenue model, then investors should hold on to the shares. When sentiment revives, there will be good demand
for such stocks,” says Indiabulls Securities CEO Divyesh Shah.
Experts say there are three major reasons for lack of liquidity — low equity base, low floating stock and lack of market-makers.
Brokers say large number retail investors are stuck in these counters and have suffered heavy losses. “Many of them have these
stocks as part of their portfolios and it is difficult for them to exit now,” says a dealer at a retail broking firm.



4. Exchange rate risk: Risk that arises due to exposure of firm cash flows to currency
Example: Effect of Exchange Rate Risk on Infosys Ltd Cash Flow
Cash Flow Statement of Infosys Ltd:



Net Income (Loss)






Deferred Income Taxes



(Increase) Decrease in Receivables



(Increase) Decrease in Prepaid Expenses



(Increase) Decrease in Other Current Assets



(Increase) Decrease in Payables



(Increase) Decrease in Other Current Liabilities.



(Increase) Decrease in Other Working Capital



Other Non-Cash Items



Net Cash from Continuing Operations



Net Cash from Operating Activities



Sale of Short Term Investments



Purchase of Property, Plant, Equipment






Purchase of Short Term Investments



Other Investing Changes Net



Net Cash from Investing Activities



Issuance of Capital Stock



Payment of Cash Dividends



Net Cash from Financing Activities



Effect of Exchange Rate Changes



Net Change in Cash & Cash Equivalents



Cash at Beginning of Period



Cash at End of Period




5. Country risk: Risk that arise due to uncertainty of political and economic stability of a
given country.
Condensed book review by Caroline Baum (a columnist with Bloomberg News in New York)
Book Title: Roger Lowenstein's When Genius Failed: The Rise and Fall of Long-Term Capital Management.
The book chronicles the history of a hedge fund (hedge fund, in finance, a highly speculative, largely unregulated
investment device. Originating in the 1950s, the funds "hedge" by offsetting "short" positions (borrowing a security and
then selling it at a higher price before repaying the lender) against "long"
It's a tale of John W. Meriwether (born August 10, 1947 in Chicago, Illinois) is an American financial executive on
Wall Street seen as a pioneer of fixed income arbitrage. John Meriwether and his professors, the best mathematical minds
from academia, who were fabulously successful as Salomon Brothers' legendary bond arbitrage group in the 1980's.
When he started his own firm in 1993, Meriwether added former Federal Reserve Vice Chairman David Mullins, and
two soon-to-be Nobel Laureates in economics, Myron Scholes and Robert Merton. Based on his reputation, Meriwether
raised $1.25 billion to start. Investors were so eager to get a peek at the inner workings of the mysterious hedge fund that
they financed 100 percent of LTCM's positions.
Long-Term enjoyed enormous success at first, returning 20 percent to investors in 1994 and more than 40 percent in
1995 and 1996 by making big bets on small discrepancies in related markets. It bought securities that were cheap and
sold securities that were expensive, based on a mathematical model of historical relationships that assumed markets
become more efficient over time; the reduction in uncertainty was bound to narrow the spread between risky and riskfree assets.
That model broke down in August 1998, when Russia defaulted on some of its debt (COUNTRY RISK). Investors fled
assets with any credibility it risks and sought safety in risk-free sovereign debt, especially U.S. Treasuries. "In every
arbitrage LTCM owned the riskier asset; in every country, the least safe bond," Lowenstein writes. "It had made that one
same bet hundreds of times, and now that bet was losing" That August, the fund lost $1.9 billion, 45 percent of its

Keeping all these factors in mind we can define Require rate of return on a risky investment as
Required rate of return = Risk free rate of return (interest rate say on bank deposit) + risk
premium, where
Risk Premium = f (Business Risk, Financial Risk, Liquidity Risk, Exchange Rate
Risk, Country Risk)

2.3 What are interest rates?
It is safe to assume the real rate of interest mainly reflects the time value of money. As we know,
investment is forgoing current consumption for higher future consumption. The inherent
assumption in this definition is that we are going to consume higher than the current value. This
higher value is expected mainly for two reasons: First, there is demand for the money you forgo
and those who want to consume now are happy to pay you more if you can fulfil their current
consumption needs. Second, there is uncertainty that the person borrowed for current
consumption may not return your money on the future date and hence you demand a premium
for bearing this risk and hence the extra higher return after taking care of time value is to

For example, if you have a surplus of Rs.1,00,000 and would like to consume it only after 2 year
from now then you can invest it in a bank which is going to consume now by lending it to
someone else (intermediation of funds). If the bank promises you to pay a return of 5% (on your
investment) per annum then you consume Rs. 1, 10, 250 (100000*(1.05)2) after two years. This
return on investment is mainly the time value as the default risk of a bank is assumed to be quite
So interest rate, in a simple sense, is the growth rate of your purchasing power. Sometimes, the
real purchasing power may decrease even if the growth rate on your investment is high. This can
be due to the general increase in the goods that you are willing to purchase. For example,
extending the above example, let us assume that the investment value of Rs. 1,10,250 (2 years
from now) is planned to consume in the form of buying a personal computer. And further assume
that the price of personal computer now is Rs. 1,10,250. If the price of personal computer
remains unchanged even after two years then theyour real purchasing power remains constant.
On the other hand if the price of personal computer, in two years time, increases to say Rs.
1,50,000 then your purchasing power is going to decrease. This phenomenon of reduction in your
purchasing power for future consumption is called as inflation.
Hence the real growth in the purchasing power is
Growthof Pr ices

1 r
1 i

=1+ real purchasing power rate (rr)

Now the real can be written as rr =

r i
1 i

In simple words, real rate of interest (purchasing power) is the difference between nominal rate
(r) and the rate of inflation (i).

2.3.1 What determines the rate of interest?
In an ideal world interest rates are determined by the “need” for current consumption of funds
and “willingness” to forgo current consumption. In other words, demand and supply for funds
drives the rate of interest. If number of people to consume now outweighs number of people to
consume in the future then the demand for funds pushes interest rates upward. Likewise, if the
number of people to consume in the future outweighs the number of people to consume now then
the supply pushes the interest rates downwards. However, leaving the rate fixation entirely to the
market forces may clash with the interest of a given economy. For instance, if the objective of
the economy (government) is to control oversupply of funds as it might decrease purchasing
power of the people then government intervenes and regulates the rate of interest to be charged
during such over supply periods. Thus, government policy is another determinant of interest
rates. The government policies are in turn determined by growth rates in the consumer goods
prices (inflation) and the future growth rates of the economy. In summary, interest rates are


determined by: 1. Demand and supply for funds; 2. Government policies; 3. Inflation; and 4.
Economy’s future growth rate.

Example: India Inc urges RBI to maintain status quo on interest rates
Financial Express: Oct 15, 2009 at 2246 hrs
The India Inc has urged the Reserve Bank of India (RBI) to continue its soft monetary stance for some more time. The
demand comes in the wake of the development where government is inclined to continue its stimulus package to increase
the credit growth across the sectors. “We have demanded that RBI should not do any contraction of monetary measures
and should not change its key policy rates to reduce money supply. We feel that the interest rates being charged by banks
for lending to the sectors like SME are still high and hence they need to be brought down,” Ficci president Harsh Pati
Singhania said. He was speaking after the consultative meeting with the RBI governor D Subbarao ahead of the credit
policy in Mumbai on Wednesday. The RBI will be reviewing its annual monetary policy for the second quarter on October
27. Singhania added that soft monetary policy would help bring more investments in these sectors. “The business
confidence survey, which was conducted by Ficci in recent past shows that India Inc needs to have more time to maintain
status quo on the interest rates until investments picks up,” said Singhania. The RBI governor, on his part, gave various
points during the interactions. The meeting comes after the industrialists meeting with the finance minister, Pranab
Mukherjee, in New Delhi on October 9, 2009. Talking about his interaction with finance minister, Singhania said, “Intent
of the proposed new direct tax code is good, Still, I think there are certain issues that need to be addressed. At the end of
the day, it should get easier and more investment friendly---both domestic as well as foreign. Finally, it should help
growth of the Indian industry. Like, there is a provision of imposition of 10-15% tax on charitable trusts.”

The link between interest rate and discount rate:
Going back to the previous example, the future value of current consumption is Rs. 1,10,250.
Given that you know the future value, we can work back words to find out what is the present
value of Rs. 1,10,250.
presentvalue( pv)(1  r )i  futurevalue( fv )
pv 

(1  r )i

This implies that future value is discounted with the rate of interest received for calculating the
present value. Hence, interest rate is also called as discount rate.
2.3.2 Interest rate, inflation and investments:
Given that we discount the present value with the rate of interest (which also includes inflation),
if the interest rate goes up the present value goes down. Hence, all else equal, an increase in the
interest rate should reduce the investments by firms. As the expected return on investment
increases (note interest rate is part of the expected return equation) the net present value (present
value of the future cash flows less present value of the current cash outflow) will shrink and
firms will start feeling stop further investments. This phenomenon is generally called as “over

heating”. Then government intervenes by bringing down the interest rates through its monetary
policy with an objective to spur the investment (which further spurs the future growth rates of the

Example: DLF's Singh Wants India Rate Cut as Home Demand Drops
By Kartik Goyal:
Sept. 18, 2007 (Bloomberg) -- Billionaire Kushal Pal Singh, chairman of India's biggest property developer by market value
DLF Ltd., said the central bank should reduce interest rates from a five-year high because of falling demand for homes.
``I don't agree with the monetary policy and I want the interest rates to be reduced,'' Singh, the fifth-richest Indian according to
Forbes in March, said at a press conference in New Delhi today. ``The earlier they do it, the better.''
Mortgage lenders have charged borrowers more since the Reserve Bank of India raised rates six times in 18 months. In Gurgaon,
outside the capital New Delhi, home prices have dropped 25 percent to 60,000 ($1,480) rupees a square yard in the three months
to March, according to data compiled by Bloomberg.
``The rise in interest rates is definitely one of the major factors that is deterring home buyers,'' said Anshuman Magazine,
managing director of CB Richard Ellis Group Inc., a New Delhi- based real-estate adviser. India's central bank has been raising
interest rates to curb inflation and prevent the economy from overheating. It has raised the repurchase rate, or the rate at which it
injects funds into the banking system, to 7.75 percent. The central bank has since December increased the cash reserve ratio by 2
percentage points to 7 percent to slow down loans growth. The Reserve Bank is scheduled to make its next monetary policy
announcement at the end of next month. `Subdued, Suppressed'
``Due to the increase in the mortgage rates, the market is subdued and suppressed temporarily,'' DLF's Singh said. ``There is a
slowdown on the mortgage side of the market.'' The ``middle and higher-income groups'' are most affected, he said. In the next
three years, 200,000 homes will be built in India's seven biggest cities for middle- and high-income groups, property adviser
Knight Frank LLC said in a report in July. Homes for the middle-income group will typically cost 2.5 million rupees to 5 million
rupees. The increase in home loan rates to 12 percent this year from 7 percent in 2003 has raised borrowers' monthly liability by
about 3,250 rupees, the Associated Chambers of Commerce and Industry of India, a business lobby group, said in a report
released by Singh today.

2.3.3 Yield Curve and Investments:
The relation between duration of the investment and the return (yield) on the interest bearing
securities (let us call them bonds for simplicity) is called the term structure of interest rates. If you
graph duration on the x-axis and return on the y-axis then you expect higher returns for longer
duration bonds (assuming the both are risk-free). In other words, the yield curve slopes upwards
indicating the borrower has to pay higher rate for longer duration bonds as the lender forgoes
consumption for a longer period of time and thus bears more uncertainty on the value of the
investment (inflation effect for pure risk free bonds) and greater chances of default risk (for risky
bonds) .


Extending the above argument, we can say that the difference between same risk long term bond
and a short term treasury bill (normally short term interest bearing securities are term as treasury
bills instead of bonds) has to be positive. The difference is termed as yield spread. The differences
in the yield spread overtime can reflect the demand for short term and long term securities. If the
demand for short term securities is higher (lower) then the yield spread contracts (expands)
reflecting an increase (decrease) in the short term interest rate. The demand for short term versus
long term securities is considered as investors’ expectations on the economy. Contraction of yield
spread is interpreted as pessimism of investors’ expectations on the future outlook of the economy
hence more people invest in the short term (as they are uncertain) the less on the long term. Some
time the yield spread can be negative. This is a very serious “running away from the market”
which will eventually stop the market liquidity and thus can lead recession (negative productivity
of the economy). If this expectations hypothesis is true then one should be able to predict
economic conditions based on the shape of the yield spread. Below is the yield spread graph based
on US market treasury (government) long term (10 years) and short term (3 months) securities.
During 1959 to 2009 US economy had around 6-7 times negative yield spread, the long bars
indicate the periods when US economy underwent recession. It is striking from the graph that
negative yield spread is always followed by recession. The most recent one is the subprime based
financial crises, the peak of the crisis was 2008 and US experienced negative yield spread in the
year 2007. Hence, yield spread is a reliable leading indicator of economic conditions (as it reflects

Source: Federal Reserve of New York

2.4 Basics of Return and Risk
2.4.1 Measuring Investment return:
Investment return can be historical return which is measured at the end of the holding period or
the expected return that investor expect to receive end of investor’s holding period. Historical
return is defined as the difference between the initial value (forgone consumption) and the end
value (value realized for consumption at the end of the holding period). In a simple equation
Historical return or Holding Period Return (HPR) = Value at the end of the holding period/ Value
at the begging of the holding period
If the holding period is for many years then it is difficult to compare with other investment
returns that are generally represented in per annum basis. Hence for better comparison we can
convert HPR in to annual value by using the following equation
Annual HPR = (HPR)1/n
2.4.2 What is the expected return?
If the future return is known at the time of investing then measuring expected investment return
is similar to the above equation. However, if the future return is not known at the time of

investment then measuring expected return becomes quite complex. It can be a mere guess work.
One has to assign some probability of receiving the return.
The normal probability outcomes can be broadly classified into three types: 1. Higher than the
current return (positive return); 2. Lower than the current return (negative return); and 3. Same as
the current return (no change).
The problem with the above approach to measure expected return is that there can be many
expected out comes other than the base case three outcomes as represented in the above example.
It is almost impossible to measure expected return unless we know all the infinite outcomes. One
simple way to overcome this problem is to assume returns distribution as normal distribution and
use mean (average) value as the expected return. In the case of normal distribution, with mean
zero (equal probability of the outcomes) and finite variance, the expected value is the mean
value. To my knowledge, the concept of normal distribution is the foundation of modern finance
and it is by and large the most significant application of statistics in finance. Hence it is
important to know more about normal distribution.
The concept of normal distribution:
Let us revisit the above example. We expected three possible outcomes (positive, no change, and
negative) for a single period. Now if we extend that example for multi period setting then, during
the second period, the return following any one of the previous three paths (positive or negative
or no change) is equally likely. Hence, in the second period the probability of the return being
positive or negative or no change is 0.33 (1/3). In other words, the return expected to be positive
has only 0.33 probability and the remaining 0.67 probability is assigned to not being positive.
This tree can be extended to many periods with many outcomes. This tree structure is termed as
binomial tree.
A simple example of binomial tree: flipping of coin1
The four possible outcomes that could occur if you flipped a coin twice are listed in Table 1.
Note that the four outcomes are equally likely and note that the tosses of the coin are
independent (neither affects the other). Hence, the probability of a head on Flip 1 and a head on
Flip 2 is 1/2×1/2=1/4. The same calculation applies to the probability of a head on Flip one and a
tail on Flip 2. Each is 1/2×1/2=1/4.

First Flip
Table 1: Four Possible Outcomes

Second Flip

1 Some inputs are taken from

The four possible outcomes can be classified in terms of the number of heads that come up. The
number could be two (Outcome 1), one (Outcomes 2 and 3) or 0 (Outcome 4). The probabilities
of these possibilities are shown in Table 2 and in Figure 1. Since two of the outcomes represent
the case in which just one head appears in the two tosses, the probability of this event is equal to
Number of Heads
Table 2: Probabilities of Getting 0,1, or 2 heads.

Figure 1: Probabilities of 0, 1, and 2 heads.

Figure 1 is a discrete probability distribution: It shows the probability for each of the values on
the X-axis. Defining a head as a "success," Figure 1 shows the probability of 0, 1, and 2
successes for two trials (flips) for an event that has a probability of 0.5 of being a success on
each trial. This makes Figure 1 an example of a binomial distribution
Figure 2 portrays binomial distribution approximated to a normal distribution when we flip the
coin 12 times.

Figure 2: The normal approximation to the binomial distribution for 12 coin
flips. The smooth curve is the normal distribution. Note how well it
approximates the binomial probabilities represented by the heights of the blue

Thus, normal distribution is a continuous distribution which is nothing but an approximation of
binomial distribution with infinite positive and negative outcomes. When there are infinite
positive and negative possible outcomes then the expected value that is at the middle of the bell
shape curve, similar to Figure 2 (as the middle portion has the maximum expected outcomes), is
zero (positive and negative values will cancel out) which is also the average of all possible
outcomes. In other words, mean or average value is the expected value in normal distribution.
Similar to Figure 2 one can plot historical returns and interpret expected return and risk through
normal distribution curve. Figure 3 graphs the frequency distribution of percentage daily return
of Infosys Ltd stock for the period 2002-09. The graph is close to normal distribution bell shape
curve (however, is not perfect symmetry. The magnitude of the positive returns is higher than
negative returns. It is difficult to find stock with perfect historical return distributions as normal
distribution in the real world. Generally returns are biased towards positive side of the
distribution). The figure indicates, out of 1742 trading days, around 700 days (41%) Infosys gave
a return of around o. 16 % per day. Around 200 days (10%) it gave a return of around -2% per
day and around 570 days (32%) it gave a return of around 2% per day. Given that Infosys
historical return distribution is close to normal distribution then expected return of Infosys can be
approximated to its historical average. The daily historical average return of Infosys is 0.044 %.
Now we can interpret that expected return of Infosys is 0.044% per day. Does that mean we can
expect 0.044% return on the next trading day. The answer is NO. Given that it is a probability
distribution, the likely hood of getting a return will always have probability less than 1 (as the
future is not certain).
One way to assign the probability for the expected return is to first calculate the mean deviation
of the historical return from its mean value. This measure is called as standard deviation or risk
of an investment (will be discussed more later).








Figure 3. Frequency distribution of Infosys Ltd Daily return % 2002-092
(x-axis: percentage return; y=axis: count of returns)
The standard deviation of Infosys stock is 3.28 %. This indicates that there is a risk of getting
below or above the mean value by 3.28%.
Using the information of mean and standard deviation, we can convert any random value say
To a standardised Zi value which is a measure of the number of standard deviations from the
mean. This transformation can be done using the following equation:(For example if X is
normal with mean μ and variance σ2), then

The distribution of Zi has mean of zero and standard deviation of one.
Now, for example if you want to know what is the probability of receiving the expected
return that is above -5% and below +5%, then we can use the Z value equation.
For -1% the Z-value will be: (-5 – 0.044)/3.28 = -1.53 and for +2% the Z-value will be: (50.044)/3.28 = 1.51. Each Z value will have corresponding area value (in the normal
distribution) in Z table. The corresponding Z value for -1.53 (or 1.53) is 0.4370 and for 1.51
it is 0.4345. The sum of both these values gives the total area under normal distribution that
is within the range of -5% to +5%. Hence the probability of receiving a return that ranges
between -5% to +5 % is around 87% (0.4370+0.4345). Notice that as the range narrows
(getting closer to the mean value) the probability decreases.
2 Adjusted prices of Infosys Ltd are sourced from Yahoo Finance.

2.4.3 How to measure risk?
Risk is the uncertainty that the expected values are not realised. Given that the future is
unknown it is almost impossible to predict the expected future value of an investment when
the future returns are not guaranteed (risk free securities mainly issued by the Government).
Risk is inherent in all investments.
We should not attach any negative connotations to risk since we cannot get positive return
beyond the risk free rate if there is no risk. Risk conveys only uncertainty but not negative
Investors and risk attitudes:
Investors vary in terms of risk preferences. Finance theories broadly classify investors into
three categories based on investors’ attitude towards risk.
(1) Risk averse investors expect positive risk premium for taking additional risk that a riskfree security. The risk premium increases with the increase in the risk of the security. For
example, let us assume that NIFTY Index of the National Stock Exchange of India gives
10% return and the Treasury bill gives 5%. However, NIFTY may or may not give 10%
with certainty. Let assume that the next year being bull or bear market is equally likely
and NIFTY on average given 40% in the bull market and -20% in the bear market. They
the expected return of NIFTY is (0.5 (40%) + (0.5)-20%) which is 10%. In this case the
extra 5% (compared to the risk free rate of 5%) is demanded as risk premium by the risk
adverse investors. Assuming investors as risk averse is considered more realistic.
(2) Risk neutral investors invest purely by looking at the expected returns of the investors.
They do not have diminishing marginal utility by taking higher risk. In the case of risk
averse investors as the risk increases their risk premiums (or the discount factors)
increases and hence the utility derived decreases. Where are in the case of risk neutral
investors they prefer to take higher risks as long the expected returns are high.
(3) Risk seeking or loving investors invest without considering risk as a dimension in their
investment decision. In other words, even though winning or losing is equally likely then
always invest and their investment decision is no even determined by their realised values
of the past investment. These characteristics are similar to gambling.
Risk is very difficult to measure and one needs to make some assumptions while constructing
risk measure. One simplest way to measure risk is by assuming that returns are normally
distributed. If returns are normally distributed then the expected value is the mean return or
simply the average of historical returns. Any deviation from the average value then becomes a
measure of risk. If we sum all the deviations and divide them by the number of observations then
we can an average measure of risk. In a normal distribution setting such average deviation
number becomes the expected risk measure. We can put this concept into an equation as follows:

 Nifty  
t 1

 RNiftyt  R
N 1 


The above equation represents standard deviation (

) of Nifty Index. Where it is represented as


t 1

sum of (

) all deviations of Nifty returns (from time t to N) from its mean or expected return
 RNiftyt  R
N 1
and the average of sum value
. We first take square of deviations (variance of
the return) and then square root to get the standard deviation. The square root ensures
representing risk as either positive or negative value.
The below histogram graphs the monthly returns distribution of Nifty during January 2002 to
October 2009. The expected return or the historical average of Nifty during the above mentioned
period is 2.22 % per month and the standard deviation is 8.34 %. This indicates that the future
monthly return of Nifty can be in the range of -6.12% (2.22 -8.34) or 10.55% (2.22+8.34).
However, these values hold only if the return distribution is normal.

Nifty Monthly Return Distribution



Is the return distribution of Nifty normal? Not 100%, you can observe that the tails of the
distribution are lumpy. In a normal distribution curve the tails should have zero value. As the
mean and the standard deviations explain all the distribution properties. These deviations of
Nifty from normality could be for two plausible reasons. (1) for perfect normal distribution there
should be large number of observations (ideally 1000s) however for the Nifty curve we used only
86 observations; and (2) May be Nifty doesn’t fit into normal distribution. If the second point

holds true, then we can’t measure risk using standard deviation. This leads to a serious issue that
the risk of Nifty is difficult to define.
Out of the 86 monthly return observations of Nifty there are 30 negative returns and 56 positive
returns. As per normal distribution the likelihood of positive or negative should be same,
however, in the case of Nifty the distribution is skewed towards the positive returns compared to
the negative returns. Hence, the skewness of Nifty returns becomes another measure of risk. In
mathematical parlance, if standard deviation is the square of return deviations then skewness is
 RNiftyt  R


the third moment (cube of return deviations from mean value)
.As the cube term can
capture more extreme values than the square term we use longer window to capture the extreme
 RNiftyt  R


values. We can stretch the width of the window to capture fourth moment
called as
Kurtosis. In a normal distribution skewness and kurtosis should be zero, however, for Nifty they
are -0.43 and +1.76 respectively. This indicates that Nifty monthly return series of the sample
period slightly violates normal distribution and hence we need to consider other measures of risk.


Alternative measure of risk:
Apart from skewness and kurtosis one popular measure used by the practitioners is Value-at-Risk
VaR can described through the following scenario: Suppose an investment manager need to
assess what is overnight loss to his portfolio in the worst case scenario with some degree of
confidence (say 95%). Then VaR can be used to measure the worst case scenario loss. For
example, if the investment manager has Rs. 10 crores of assets under management with
overnight-95% confidence interval VaR of Rs. 40 lacs then it means that 19 times out of 20 his
biggest loss should be less than Rs. 4 lacs. You can also express VaR as a percentage of assets, in
this case 4%.
Interpretation of VaR numbers:
Concept Test:
Example: A VaR of Rs. 1 crore, with 87% confidence level: Which is true?
1. Portfolio is expected to return at least 13%?
2. Portfolio manager is 87% sure he will earn less than Rs. 1 crore?
3. Portfolio manager is 87% sure he will not lose more Rs. 1 crore?
4. There is a 13% chance that the portfolio will earn more than Rs. 1 crore?
Calculating VAR
VAR = Market Value x Confidence Factor x Volatility
Portfolio value Rs.10crores; Daily volatility 5%; and Confidence level = 88%
(Normal Distribution table value for 88% is 1.17)
DAILY VaR = 100000000 x 1.17 x 0.05 = Rs.585,000
Interpretation: there is a 12% chance the portfolio will lose more than Rs.585,000 in a day.
Risk-Return relationship: Historical perspective
Risk and return are positively correlated: the higher the return the higher is the risk. This can be
demonstrated through historical trends of return and risk not just in India but all over the world.
The below graphs depict the relationship by categorising investments into different asset classes
and different markets. Return on equities (risk securities) is higher than treasury bills (risk free
securities). And this holds across all markets. One important concept these graphs depict is that
over 100 years by taking risk, although the probability of high and low return has to be equal, on

average investors received higher returns. Investors kept paying more premiums for risky assets.
This in a way proves that risky assets are better investments in the long run.
Historical risk and return patterns across the world
The below figure shows year wise distribution of ranges of US market returns over hundred
years. It is clear from the distribution graph that US market had more positive return years
compared to the negative year returns. This confirms that returns in general are positively
skewed (similar to Nifty monthly returns) over long periods of time.
Source : Professor. Simon Benninga ‘s (Tel Aviv University) compilation.

Do returns of other asset classes follow normal distribution?
As you can see in the below figure, bonds have better normal distribution than stocks and
emerging markets have fattest tails. This shows that we can use uniform measure of return and
risk for all markets and all asset classes.


Indian Returns: Historical perspective


oneday Hars
declin had
Firste in Meht
MajorUS, a
Bull no Sca
linkag m
e then

cted bul



Returns Based on Asset Classes in India (Source : Sundaram BNP Paribus website)
Asset Class
























Bond yield













UK returns: Historical Perspective
UK asset classes returns during 1900 -2000

US asset classes returns during 1900-2000

Other countries returns and risk: Historical perspective
Returns of assets classes in other countries:


Standard deviation of returns (risk) of assets classes in other countries:

Source for Figures x-x: Professor. Simon Benninga ‘s (Tel Aviv University) compilation.