Lecture 5 & 6

Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2019.
Instructor: Dr. Sohail Zafar. TA: Ms Maheen Chaudhry
Lectures 5 & 6
Return on Standalone Stock

Realized rate of return on standalone stock, also called ex-post –facto return, actual
return, historic rate of return is known and there is no disagreement about it . For
example you bought a share a year ago at 200, it gave during the year 5 Rs cash
dividend, and you sold it after one year at 250. Then your realized rate of return is:
Realized ROR = DPS received / purchase price + (Selling Price - Purchase Price) / Purchase Price
= 5 / 200 + ( 250 - 200)/200

= 0.025 + 0.25
= 0.275 or 27.5%
expected rate of return (Kc) on a standalone stock is
expected ROR = expected DPS1 / P0 + (P1 - P0) / P0
= 10 / 100 + (120 - 100)/ 100
= 0.1 + 0.2
= 0.3 or 30%
P0 refers to current price; P1 refers to expected price after one year; expected DPS1
refers to expected cash dividends per share during the next year.
Note: Under the assumption of 5 corporate policies remaining constant year after
year ( that is, net profit margin, total asset turnover, financial leverage, dividend
payout ratio, and number of shares outstanding), constant growth rate in DPS, and
P0, and many other variables such as sales, TA, NI, EPS is estimated as:
g = ROE ( 1 - d), whereas d = DPS/EPS
and expected DPS1 next year is estimated as = DPS0 ( 1 + g), DPS0 is the latest
dividend paid by this share.
and expected Price next year, P1 , is estimated as = P0 (1 + g)
Please note the similarity of formulas for realized and expected ROR.
On different assets annual expected and realized rate of return is composed of 2
components: an income yield and a capital gains yield. For example
On shares ROR = dividend yield + capital gains yield
DPS / P0 + (P1 - Po) / Po
On bond ROR = interest yield + capital gains yield
= interest received / Po + (P1 - Po)/Po
On plot of land ROR = (P1 - Po)/Po, as there is no income
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On a rented house / plaza = rent income / Po + )p1 - Po)/Po

On Paintings = (P1 - Po)/Po, as there is no regular income
On Jewellery = (P1 - Po)/Po, as there is no regular income from jewellery
Precious metals = (P1 - Po)/ Po, as there is no regular income from this asset
Antique/ furniture = ( P1 - Po)/Po, as these assets give no regular income
T- bills = (P1 - Po)/Po, as t-bills give no regular income, you earn interest from t-
bills in the form of increase in its value which reach’s on the maturity date to its
face value while the bill is issued initially at a discount from its face value, the
difference between face value and issue price is interest amount. And the same is
true for all those securities that are discount securities such as bankers
acceptances, repos and reverse repos, etc.
Return on Portfolio
Instead of investing in one security, if you invest in multiple securities, then it is
called portfolio. On portfolio of stocks you can calculate percentage realized rate of
return and percentage expected rate of returns. Percentage rate of return (ROR) of
a portfolio would be denoted as Rp. In this lecture you would learn to calculate
realized Rp and expected Rp on portfolio of stocks.
background Info about professionally Managed Portfolios

for Example Mutual Funds
One example of professionally managed portfolios is mutual funds. Mutual funds
portfolios can be divided into 2 types: open ended funds and closed ended funds.
Open ended mutual fund has this name because cash inflows and cash outflows are
experienced by such a portfolio during the holding period. The closed ended
mutual fund receives cash inflows only once, when it is formed in a very similar
manner as an IPO (Initial Public Offering) of shares of a company; and thereafter no
further cash inflows occur, and also no cash is taken out of a closed ended portfolio
until it is liquidated and its life is therefore terminated.
In Pakistan almost all large commercial banks have established subsidiary
companies called AMCs (Asset Management Companies). AMCS are involved in the
mutual funds business. And these AMCs launch for public both open ended and
closed ended mutual funds investment schemes so that individual investors can
become shareholders of professionally built and managed portfolios instead of each
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individual investor attempting to build his / her own portfolio. Please note, legally
each mutual fund is a separate entity with its own income statement and balance
sheet, and owner of this entity are its unit holders (shareholders), that is general
public, though at least 20% shares are required to be subscribed by the AMC that
launched that fund. This regulation is aimed at avoiding moral hazard that the AMC
managing a fund makes unnecessary risky investments if only public money is being
managed, therefore if a portion money is coming from AMC then the AMC has
stake in fund’s performance and hopefully won’t do excessively investment with the
public’s money while managing the fund.
One asset management company (AMC) is allowed to launch multiple mutual funds
with different investment strategies to attract investors with different investment
preferences, such as equity funds, bond funds, money market funds, balanced
funds, growth funds, capital protection funds, islamic equity funds, etc
Open ended funds
In Pakistan the oldest examples of open ended mutual fund portfolio is NIT. Market
value of assets under management of open ended mutual funds is more than 28
times the assets under management of close ended mutual funds in January 2018.
Assets in this context refer to shares, bonds, other securities in which investment
was made to build the mutual fund portfolio. Net assets refer to MV of assets of a
mutual fund minus TL, which are typically insignificant as mutual funds are not
allowed to take bank loans or issue bonds to raise funds. All financing comes in a
mutual fund as OE provided by general public and AMC who buy shares of a mutual
fund; usually these are called units. You can find more detail on the website of “The
Mutual Funds Association of Pakistan”. www.mufap.com.pk/.
An AMC ,NAFA, which is a subsidiary of NBP (National Bank of Pakistan) has more
than 96 billion Rs worth of financial assets under management of its 28 open ended
mutual funds, their largest fund is NAFA Money Market fund with assets 22.5 billion
Rs and the 2nd largest is NAFA stock fund with assets 16.6 billion Rs. NIT manages 6
open ended funds that have total 91.89 billion Rs of assets under management, the
largest fund is National Investment Unit Trust with 75.55 billion Rs of assets under
management and it is the largest equity fund in Pakistan having invested in shares
of all the listed companies. MCB Stock Market Fund is another large equity fund in
the open ended category with 10.4 billion Rs of assets under management. Atlas
Income fund has about 9 billion Rs of assets under management, and it is an income
fund that invests only in regular income generating assets such as corporate bonds
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(TFCs) and Government bonds (PIBs). Meezan bank’s subsidiary AMC has 23 open
ended mutual funds, largest being Meezan Islamic fund, a Sharia compliant equity
fund with assets under management exceeding 37.4 billion Rs. ABL (Allied Bank
Limited) has 17 open ended mutual funds under the management of its subsidiary
AMC with asset of about 37.7 billion Rs, the largest fund in this group is ABL cash
fund with assets under management exceeding 13.8 billion Rs, and it is a money
market fund investing in short maturity debt instruments such as t-bills. HBL asset
Management Company has under its management 19 open ended mutual funds
with total asset worth 39.4 billion Rs, their largest fund is a money market fund
called HBL Cash fund with assets worth 10.1 billion Rs under its management.
Almost 575 billion Rs (about 5.75 billion US dollar) of assets were under
management of open ended mutual funds in January 2018. This amount seems
almost insignificant in comparison to a single American asset management
company such as fidelity that has asset under management (AUM) exceeding 1,900
billion US dollar. https://www.fidelity.com/about-fidelity/fidelity-by-
numbers/corporate-statistics
Shares (units) of open ended mutual funds are not listed and are not traded on the
stock exchange. To invest in an open ended mutual fund, such as NIT, investors
have to go to the nearest branch office of NIT (one is located in Main Market,
Gulberg), and investor gives cash and gets units (shares) of NIT mutual fund
portfolio. Similarly an investor who had invested in NIT units in the past, and wants
to liquidate that investment, would need to go to the nearest NIT office and sell his
units and get cash. These units (shares) of open ended mutual funds are not traded
on the stock exchange, but NIT and other open ended mutual funds do announce
daily the selling price and re-purchase price of their units in the media/ web sites.
These open ended mutual funds set the daily selling price of their units slightly
higher than NAV (net asset value) and re-purchase price lower than the NAV of their
unit, the difference being the spread or the profits they make on issuing shares to
investors and repurchasing the same shares from the investors. Due to this activity
the size of an open ended mutual fund portfolio changes daily as it experiences
daily cash inflows and outflows; hence the name open ended.
NAV per unit = (MV of TA – TL of mutual fund)/ number of units outstanding (that
is shares of mutual fund)
Closed ended mutual fund portfolios
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These mutual funds are listed and traded on the stock exchange; and their unit
price (share price) is reported daily in the news paper in the same way as prices of
shares of other companies are reported. Please note that shares (units) of a closed
ended mutual fund usually trade in the stock exchange below their net asset value
(NAV) because the price in the stock market depends on demand and supply on
that day. You can buy and sell units of closed ended mutual fund through your
stock broker as you do for shares of other companies. There are only 3 closed
ended mutual funds with total assets under management of about 20 billion Rs
which is only 3.5% of the total assets under management of open ended mutual
funds as of January 2018. The largest closed ended mutual fund is PICIC Growth
fund with assets of 12.9 billion Rs and is managed by HBL AMC. You can go to the
given link to see the latest per unit payout (that is something like DPS) given by
each mutual fund http://www.mufap.com.pk/payout-report.php?tab=01
AUM (asset under management) of a mutual fund are MV of its TA on that date
and it is the sum of MVs of all the shares (or bonds or other securities such as t-
bills, and balance in bank accounts) in which that mutual fund has invested, and TL
are usually very small such as utilities payable and fee payable to the asset
management company (AMC) which manages the mutual fund portfolio; but
mutual funds are not allowed to have bank loans liabilities or raise any other type of
debt by issuing bonds or sukuk (Sharia compliant bonds).
A hedge fund is a highly leveraged portfolio having a balance sheet like:

TA = TL + OE
100 = +98 + 2
And its OE is provided not by general public but a small group of selected rich
individuals, and it carries huge liabilities usually as bank loans taken by pledging its
assets which are investments in shares and bonds and other securities. In Pakistan
we do not have hedge funds.
A mutual fund , contrary to a hedge fund, is an all equity financed entity which has
balance sheet like:
TA = TL + OE
100 = 0 + 100
Each mutual fund has a separate legal status like any other company, and has its
own income statement and balance sheet like any other company, but it has no
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staff. Another separate legal entity called AMC manages the mutual fund, and
mutual fund pays a management fee to the AMC, and this fee is the biggest
expense on the income statement of mutual fund; whereas revenues of mutual
fund come in the form of interest income and dividend income from the securities
in its portfolio, and also as capital gains on such securities if they experience
increase in their MV in the market.
Voluntary Pension funds are also professionally managed portfolios. There are 61
voluntary pension funds with 24.8 billion Rs worth of asset under management.
Most of the pension funds were launched recently in last few years, though the
oldest ones go back to 2007. Employers may ask their employees to opt for
periodic regular investment from their monthly salary into such pension funds so
that employees build a professionally managed saving amount during their service
life and can benefit from such savings after their retirement from jobs.
Back in 2012 Pakistan based mutual funds performed very well in terms of ROR.
The following is an excerpt from a media report:
HONG KONG: Fourteen Pakistani mutual funds stormed into the list of the world’s top 100
best performing equity funds in 2012 as Asian regional markets rallied. In total, 42
mutual funds investing in Asia had made the top 100 list of mutual funds. The list
included 14 equity funds from Pakistan , 14 from Thailand and nine from India,
according to an analysis of data for 27,153 actively managed equity mutual funds
tracked by Thomson Reuters Lipper globally. The world’s top 100 equity fund’s list
ranked 14 Pakistani mutual funds among these funds; and these were: Golden
Arrow Selected Stock Fund(ranked 4th ) generating a return of 105.29% in 2012,
Safeway Mutual Fund 18th with a return of 74.23%, NAFA Stock Fund 26th
(69.4%), AKD Opportunity Fund 32nd (65.82%), JS Pension Savings Fund –
Equity Sub Fund 42nd (62.59%), Asian Stocks Fund Limited 45th (61.07%), Atlas
Stock Market Fund 47th (60.69%), JS Growth Fund 51st (60.43%), Pakistan
Pension Fund – Equity Sub Fund 52nd (60.31%), Atlas Pension Islamic Fund 80th
(57.61%), Atlas Pension Fund 90th (55.93%), Pakistan Islamic Pension 91st
(55.70%), ABL Stock Fund 96th (54.39%) and JS Islamic Fund was ranked 99th
generating a return of 54.07% during 2012. Published in The Express Tribune, January
19th, 2013.
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Closed ended portfolio’s realized Rp

Realized Rp calculations are different for open ended and closed ended portfolios.
Realized Rp = (Wealth at the end - Wealth at the beginning) / Wealth at the beginning.
Wealth at the beginning of period (W0) is composed of number of shares of stock A

* price of stock A, plus number of shares of stock B * price of stock B , and so on for
all the stocks included in the portfolio, plus any cash and other securities that are
part of portfolio at their beginning price. Similarly wealth at the end of the period
(W1) is calculated by using the end of the period price of the securities in that
portfolio plus any cash received during the holding period as dividends and interest.
This can be written as:
(𝑾𝟏 − 𝑾𝟎 )
𝑹𝒆𝒂𝒍𝒊𝒛𝒆𝒅 𝑹𝒑 =
𝑾𝟎
Your class project requires calculating weekly Rp in this manner on each of your 4
portfolios as there is initial 100 million rupees invested in each portfolio, and then
during 10 weeks no additional funds are given to you, nor are any funds taken away
from you.
Holding period return on such a portfolio for a 2- year holding period is calculated
as:
2-year holding period Rp = [(1 + Rp1)(1 + Rp2)] -1
Suppose you built a portfolio using 50 million, and it gave the Rp of – 50% in year 1,
and Rp of 100% in year 2. It was a closed ended portfolio, you neither invested
more funds in the portfolio, nor withdrew any funds from the portfolio
2- year holding period Rp = [( 1 + -0.5)(1 + 1)] -1
= 1 -1 = 0 % per 2 years.
That means your wealth increased by 0% over 2 year period, not every year. Let us
have more clear understanding as to how this 2-year holding period Rp works out.
TA0 = TL0 + OE0 (balance sheet at the beginning)
50 = 0 + 50
After one year your wealth (OE1) would be OE0 (1 + Rp1) = 50(1 + -0.5) = 25.
Therefore balance sheet at the end of year one:
TA1 = TL 1 + OE 1
25 = 0 + 25
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Rp1 = ( OE1 - OE0)/ OE0 = (25 - 50 )/ 50 = - 50% or 0.5

Then end of year 2 your wealth,OE2 = OE1 (1 + Rp2) = 25(1 + 1)= 50.
Therefore balance sheet at the end of year 2:
TA2 = TL2 + OE2 = 50 + 0 = 50
Rp2 = (OE2 - OE1) / OE1 = ( 50 - 25) / 25 = 100% , or 1
Therefore
2- year holding period Rp = [( 1 + -0.5)(1 + 1)] -1
= 1 -1 = 0 % per 2 years.
And your wealth (W2) that is OE2 can be estimated as
W2 = W0 (1 + Rp1)(1 + Rp2)
= 50 (1 + -0.5)(1 + 1) = 50
Meaning there was no increase after 2 years in your wealth, it was 50 million at the
beginning, and 50 million after 2 years. Which means 2-year holding period Rp = 0%
is correct as there was no increase in your wealth therefore naturally you earned
zero rate of return over 2 year periods; though each year you had some rate of
return, either negative or positive, but over the 2-year period as a whole your ROR
was 0%.
Open ended portfolio’s realized Rp

As open end portfolios experiences inflows and outflows almost daily because
investors can buy more of its shares and give cash and also redeem (disinvest) from
its share and receive cash daily.
Two methods namely time weighted returns and rupee weighted returns can be
applied to calculate periodic (such as monthly, weekly, or annual) Rp. Time
weighted Rp is the correct method. Both methods are discussed below.
Time weighted realized Rp

It is common practice for open ended mutual funds to receive additional funds and
invest those to expand the size of the portfolio. Open ended mutual funds
portfolios also experience outflows during the same period when some of the
shareholders (unit holders) of an open ended mutual fund sell back mutual funds
shares to the mutual fund and get cash from the open ended mutual fund.
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As individual investor, it is also possible that you may sell for cash some of the
shares in your portfolio for personal needs, and your personal portfolio , therefore
has cash out flows. Similarly after building a portfolio, you may decide to invest
further funds to expand the portfolio, and your personal portfolio has cash inflows.
In this manner your personal portfolio would be an open ended portfolio for that
specific holding period.
For example
You have built a portfolio and MV (market value) of shares is 50 million Rs. Then by
the end of first year (or first month, or first week) its MV declined to 25 million due
to fall in prices of shares, but at that time you as investor injected another 25
million Rs that were used to buy more shares; and at the end of 2 nd year MV of
these shares in the portfolio has risen to 100 million.
Time weighted Rp :
ROR of first year = (W1 - W0) / W0
= (25 - 50) / 50 = -50%
ROR of 2nd year = (W2 - W1) / W1
= (100 – 50) / 50 = 100% or 1
Note: 25 was MV of portfolio at the end of first year, then you invested another 25
so it became 50, and therefore beginning wealth in year 2 was 50 .
2- year holding period Rp = [(1 + Rp1)*(1 + Rp 2] – 1

=[(1 + - 0.5) * (1 + 1)] -1
= 0% Rp for 2-year holding period
Note:
50 = 0 + 50
TA1 = TL 1 + OE 1
25 = 0 + 25
Rp1 = ( OE1 - OE0)/ OE0 = (25 - 50 )/ 50 = - 50%, or - 0.5
then you invested another 25 million and bought more shares; so end of year 1
balance sheet of portfolio changed to:
TA1 = TL1 + OE1
50 = 0 + 50
TA2 = TL2 + OE2 (balance sheet of portfolio end of year 2)
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100 = 0 + 100
Rp2 = (OE2 - OE1) / OE1 = ( 100 - 50) / 50 = 100%, or 1
W2 = W0 (1 + Rp1)(1 + Rp2)
= 50 (1 + -0.5)(1 + 1) = 50
So your beginning wealth (OE0) and ending wealth (OE2) should be 50 ; implying no
change in wealth. But balance sheet shows OE 2 is 100.
This method of calculating ending wealth is not applicable to open ended portfolios
if their Rps for each period were calculated using time weighted method. Yet, the
holding period Rp for 2-year of 0% given by this method is correct .
Rupee Weighted Rp :
To calculate rupee weighted Rp you use only the cash inflows and outflows of each
period. In this example you initially invested 50 million at time zero, then invested
another 25 million at the end of year 1, then at the end of year 2 the assets of
portfolio valued at MV at 100 million were sold and investor got 100 million inflows.
In FC-100 calculator go to CASH mode, enter in data editor: -50 exe; -25 exe; 100
exe; esc; solve IRR. You get 18.614% IRR , and it is a yearly IRR because your cash
flows are yearly.
In BA II Plus Calculator
Hit CF, you see CF0 on the screen, write 50, hit +/- , hit ENTER
Hit down arrow, see CO1, write 25 hit /- ,hit ENTER
Hit down arrow, see FO1 =1(that says frequency of previously entered CF, as in this
case it was once, leave FQ1 as 1 and
Hit down arrow seeCO2, write 100, hit ENTER.
Now data of CFs has been entered.
Hit IRR then hit CPT, you see after a while on the screen IRR = 18.61.
This is annual IRR as data was annual. If data were weekly, it would be weekly IRR.
2-year holding period Rp = [(1 + Rp1)*(1 + Rp2)] – 1

2-year holding period Rp =[(1 + 0.18614) *(1 + 0.18614)] – 1
= 1.4069 -1
= 0.4069 or 40.69% Rp per 2-year holding period.
50 = 0 + 50
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And actual balance sheet end of year 1 is

TA1 = TL 1 + OE 1
25 = 0 + 25
Actual realized Rp1 = ( OE1 - OE0)/ OE0 = (25 - 50 )/ 50 = - 50%
But according to rupee weighted method says , no , you earned in year one Rp of
18.614%; which is incorrect; and therefore i In your balance sheet at the end of year
1 there should be increase in TA and wealth (OE) by 18.614%, as positive Rp for
year 1 was going to increase wealth (OE), that is:
50(1 + 0.186140 = 59.31
TA1 = TL 1 + OE 1. That is balance after earning 18.614% in year one according to
rupee weighted method.
59.31 = 0 + 59.31
And Rp1 = (59.31 - 50)/50 = 18.614%, this is realized Rp for year 1 according to
rupee weighted method
But this is incorrect as end of year 1 your wealth (OE) had reduced to 25 , not
increased to 59.31
then you invested another 25 million and bought more shares; so according to
rupee weighted method end of year 1, in balance sheet of portfolio your wealth
(OE) changed to: 59.31 + 25 = 84.31; but that is incorrect because after investing
another 25 end of year 1, your OE became 25 + 25 = 50. Rupee weighted method
based balance sheet would be
TA1 = TL1 + OE1
84.31 = 0 + 84.31
TA2 = TL2 + OE2 (balance sheet of portfolio end of year 2)
100 = 0 + 100
Rp2 = (OE2 - OE1) / OE1 = ( 100 - 84.31) / 84.31 = 18.614%
W2 = W0 (1 + Rp1)(1 + Rp2)
= 50 (1 + 0.18614)(1 + 0.18614) = 68.88
But that is in correct according to cash flows; you had cash value (MV) of shares 100
at the end of year 2, and you sold those at 100 to get 100 cash flows. But according
to rupee weighted method you would have cash flows of 68.88 Rs, that is again
incorrect.
You noted that both methods of holding period Rp calculation for the open ended
portfolio do not give W2 correctly. Therefore do not use such formula
W2 = W0 (1 + Rp1)(1 + Rp2)
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for calculating wealth at the end of holding period in case of open ended portfolios.
This method of ending wealth calculation is valid only for closed ended portfolios as
you saw above under the heading Closed ended portfolios realized return.
Now, you would agree, that 2 methods of calculating realized Rp for open ended
portfolio give very different answers. In this example for 2- year holding period,
time weighted Rp is 0% but rupee weighted Rp is 46.9%. Also time weighted Rp for
year 1 and year 2 were different; but Rupee weighted Rp for year 1 and year 2 were
same, which were incorrect. The time weighted Rp is correct.
Holding Period Realized Rp for multiple

holding years for closed ended portfolios
Holding period can be any period, such as 10 weeks as in your class project, or 4
months, or a 5 year period. Rate of return earned in that period is called holding
period return.
Realized holding period returns, and wealth at the end of holding period, for both
closed ended and open ended portfolios can be calculated in the manner shown in
the example above for the 2-year holding period. Further examples are given
below. If periodic returns (such as annual Rp shown below for each of the 5 years)
for a closed ended portfolio as (W1 – Wo)/Wo then the following example shows
calculations of 5-year holding period Rp
For example you built a portfolio of shares by Investing Rs 10,000 of your own funds
(OE) and during the next 5 years your realized annual Rp were :
Year Rp Realized
1 10%
2 -7%
3 -15%
4 20%
5 5%
Questions:
1) find wealth at the end of each year, then W5 , wealth after 5 years
2) Holding period Rp (i.e. ROR for 5- year holding period), Please note that it is not
an annual ROR nor average annual ROR over 5 years.
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Solution:
W0 is wealth at the beginning of year, W1 is wealth at the end of first year, W2 is
wealth at the end of 2nd year and so on. You know that for any one year the
realized Rp is:
Realized Rp = (W1 – W0) / W0
Realized Rp = W1 / W0 – W0 / W0
Realized Rp = W1 / W0 – 1
Realized Rp + 1 = W1 / W0
(Realized Rp + 1) * W0 = W1
And it can be written as:
W1 = W0 (1 + Realized Rp)
Let us use this expression to estimate portfolio’s market value or wealth at the end
of each of the five years.
1: W1 = Wo (1 + Rp1) = 10,000 (1+ 0.1) = Rs 11,000

W2 = W1 (1 + Rp2) = 11,000 (1- 0.07) = Rs 10,230
W3 = W2 (1 + Rp3) = 10,230 (1- 0.15) = Rs 8,695.50
W4 = W3 (1 + Rp4) = 8,695.50 (1+ 0.2) = Rs 10,434.60
W5 = W4 (1 + Rp5) = 10,434.60 (1+ 0.05) = Rs 10,956.33
Or: you can use a more compact method of calculation:
W5 = Wo (1+ Rp1) (1+ Rp2) (1+ Rp3) (1+ Rp4) (1+ Rp5)
= 10,000 (1 + 0.1) (1 + - 0.07) (1 + - 0.15) (1 + 0.2) (1 + 0.5)
= Rs 10,956.33. Same as found above
2: Holding Period Returns . In this case holding period for this portfolio was 5
years so holding period rate of return would be a rate of return per 5 year period,
not per year.
Holding Period Rate of Return = (W5 – Wo) / Wo
=(10,956 – 10,000) / 10,000
= 0.0956 or 9.56% per 5 years
This method can be used only if you already have estimated W 5, otherwise the
method given below would be used, and it is the same method used in earlier
example of 2-year
Holding Period Rate of Return = [(1+Rp1) (1+Rp2) (1+Rp3) (1+Rp4) (1+Rp5)] - 1
Holding Period Rate of Return =[(1+0.1) (1+ - 0.07) (1+ - 0.15) (1+ 0.2) (1+ 0.5)] -1
Holding Period Rate of Return= 0.0956 or 9.56% per 5 years.
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Once you have found Pr for 5-year holding period, then you can find W 5 , as shown
below:
Or: W5 = Wo (1 + Holding Period Rp for 5 years)
= 10,000( 1 + 0.0956) = 10,956 Rs
But to use this last method to find wealth after 5 years you first have to estimate
holding period return for the 5 year
Expected Return on portfolio (Rp)

For the purpose of making investment decision, you are not interested in the
realized Rp because it’s a fact related to the past, and past performance of a
portfolio is not necessarily a reliable indicator of its future performance .
Investment decision are aimed at earning a rate of return in future, therefore you
should be interested in the expected Rp while building a portfolio of shares.
Expected Rp is weighted average of expected RORs of stocks included in the
portfolio; whereas weight of each stock in the portfolio is denoted as X, and it is
calculated as:
Xi = investment in stock i / your OE. ( i means any stock)
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑅𝑝 = 𝑋𝑎 𝑅𝑎 + 𝑋𝑏 𝑅𝑏 + 𝑋𝑐 𝑅𝑐 + … . . +𝑋𝑛 𝑅𝑛
It can be written in more compact form as:
𝑛
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑅𝑝 = ∑ 𝑋𝑖 𝑅𝑖
𝑎
whereas ‘ i ‘ can vary from stock ‘a’ to stock ‘n’.

Please note that: ‘a’ to ‘n’ are different stocks; ‘X’ refers to weight of each stock in
your portfolio, and ‘Ri’ refers to expected ROR of each stock in your portfolio; and
expected ROR for each stock, and is now being denoted as Ri, and it is estimated as:
Ri = DPS1 / P0 + (P1 - P0 ) / P0 (please note : now symbol Kc has been replaced
by symbol Ri for the rest of this course).
Weights of a Portfolio Must Add to One, Sum of Xi =1

Investment in a co’s stock divided by your OE is called weight of that stock in a
portfolio, and it shows proportion or percentage of your OE invested in that stock,
and is denoted with ‘x’.
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For example if out of your funds, 30% were invested in shares of Engro, 20% were
invested in shares of PTC, and 50% were invested in shares of PSO, then weight of
Engro, PTC, and PSO are respectively 0.3; 0.2; and 0.5 in your portfolio. And sum of
weights is 1.
Please be careful weight of a stock in your portfolio is NOT the proportion of total
funds invested in your portfolio because total funds used by you to build a portfolio
may come from your own wealth (OE) plus funds you take as loan to build a
portfolio. Remember balance sheet equation: TA = TL + OE.
The concept of balance sheet is applicable to portfolios as well.

For example, You may build a portfolio by investing 5 million of your funds (OE) and
borrowing 1 million from a broker or a bank (this would be TL). Suppose you
invested all 6 million in 3 stocks equally, that is Rs 2 million in Engro, Rs 2 million in
PTCL, and Rs 2 million UBL. Now your portfolio has TA of 6 million rupees in the
form of shares of 3 companies, but these assets are financed by your OE of 5 million
and loan (debt) of 1 million. The balance sheet of this portfolio looks like
TA = TL + OE
6 = 1 + 5
Such a portfolio is levered portfolio because of Debt (TL) was also used as a source
of funds to build this portfolio.
Weights of this levered portfolio are:
X Engro = investment in Engro / OE = 2/5 = 0.4
X PTCL = investment in PTCL / OE = 2/5 = 0.4
X UBL = investment in UBL / OE = 2/5 = 0.4
But sum of these weights is 1.2, so there is something wrong in your understanding
of the constituent securities included in this portfolio. In fact you have ignored the
loan amount that was used to build this portfolio. Let us include that as well as if it
is also a security in this portfolio.
X Bank Loan = investment in bank loan /OE = -1 /5 = - 0.2
Sum of weights = 0.4 + 0.4 + 0.4 +- 0.2 = 1 or 100%
Please note in this portfolio there are 4 securities, not 3. In 3 securities you
invested (and therefore took long position) and their weights (Xs) are positive in
your portfolio; but the fourth security was loan in which you did not invest rather it
provided funds so its weight is negative in this portfolio, same is true if a stock
49
were shorted to build this portfolio; its weight would have been negative. But
important thing to note is the fact that sum of a portfolio’s weights always must
add up to one. And now after including the loan as constituent security the weights
of this portfolio add up to one =
X Engro + X PTCL + X UBL + X Bank Loan
0.4 + 0.4 + 0.4 + - 0.2 = 1
And now construction of portfolio is correctly described because Sum of weights is
always one for any portfolio.
It is a very important issue, If weights of your portfolio do not add up to 1 or 100%
then you have made a mistake and all your subsequent calculations about expected
Rp and total risk, diversifiable risk, relevant risk, etc would be incorrect; therefore
you must be very careful about this issue while dealing with portfolios.
Weight of those stocks which you bought is positive, weight of those stocks you
short sold is negative in your portfolio. Also weight of loan taken to build the
portfolio is negative. Weight of certain stocks can be more than one in your
portfolio implying that you invested in that stock more amount than your own OE,
and you can do that only by taking loan. If a stock has zero weight then it is not
included in your portfolio; meaning you have taken neither a long nor a short
position in that stock, and that stock is not part of this portfolio. Whenever weight
of a stock would be more than one in your portfolio then either there would be
some other stocks whose weight would be negative or you would have borrowed
funds from broker or bank. But in any case sum of weights of all the securities in
your portfolio is always one. Do not forget that loan taken is also treated as one of
the securities included in your portfolio, though with negative weight.
For example you have 10,000 Rupees but in stock of Engro you invested 12,000 Rs
then weight of Engro in your portfolio would be:
investment in Engro / your OE = 12,000 / 10,000 = 1.2
and it is more than one. But how could you invest 12,000 in Engro if you had only
10,000? The answer lies in short selling some other share to raise funds or taking
loan from bank or broker. Suppose you also short sold POL stock worth 2,000 Rs to
build this portfolio then weight of POL in your portfolio is: -2,000 / 10,000 = - 0.2,
that is negative weight. The sum of weights of this portfolio is:
Sum of Xs = X Engro + X POL
= 1.2 + - 0.2
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= 1
Exercise : Expected Rp on an equally weighted portfolio with no leverage

1): You have 400,000 of your own funds (OE) and you decided to invest in 4 stocks
equally, expected ROR of each stock has been estimated and is given below. Please
find expected Rp.
Stock Expected Ri per year (subscript ‘ i ’ refers to any stock.)
ICI 15%
Lever 20%
PSO 22%
Engro 12%
Solution
Total amount available for investment is your own fund, OE = Rs 400,000.
In an equally weighted portfolio, amount invested in each stock is equal ; and in
this case it works out 400,000/4 = 100,000. So investment in each shares is:
ICI = Rs 100,000; Lever = Rs 100,000; PSO = Rs 100,000; Engro = Rs 100,000
To calculate weight of each stock in your portfolio, the formula is:
Xi = amount invested in a stock / your OE.
For example weight of ICI , X ICI =investment in ICI / your OE
= 100,000 / 400,000
= 0.25 or 25% of your OE.
since it is an equally weighted portfolio, all stocks have the same weight because
same amount is invested in each of the 4 stocks, so:
XICI = XLever = XPSO = XEngro
That means 25% of your OE is invested in each of these 4 stocks.
Expected Rp = XICI RICI + XLeverRLever + XPSORPso + XEngroREngro
Expected Rp = (0.25 x 15%) + (0.25 x 20%) + (0.25 x 22%) + (0.25x 12%)
Expected Rp = 3.75% + 5% + 5.5% + 3% = 17.25%
Note: It is OK to write expected RORs of different stocks as whole numbers such as
12 percent can be written as 12, but weights (Xs) of each stock must be written in
decimal points; so 25% of OE invested in PSO must be written as 0.25.
Balance Sheet of this non-levered or all equity financed portfolio
TA = TL + OE
40,000 = 0 + 400,000
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Note: since this portfolio has no liabilities in it, so it is not a leveraged portfolio. All
the funds to build this portfolio were supplied by you in the form of OE, and
therefore weights of all the stocks included in this portfolio were positive, that is
0.25.
Expected Rp on a Leveraged portfolio
Now assume you borrowed another Rs 100,000 at 10% per year interest rate and
total amount available for investment is Rs 500, 000; that is, 400,000 of your own
funds plus 100,000 loan.
Again you want to build a portfolio by investing in the same 4 stocks equal amounts.
You would divide 500,000 by 4 and 125,000 Rs is the amount you would invest in
each of the 4 stocks; so you would have long position in 4 stocks as shown below:
Stock Amount Invested Expected ROR (Ri) per year

ICI Rs 125,000 15%
Lever Rs 125,000 20%
PSO Rs 125,000 22%
Engro Rs 125,000 12%
Find
1. Weights of this portfolio
2. find Expected ROR of this levered portfolio (Rp)
Solution:
Xi = investment in a stockt / your OE
X ICI = 125,000 / 400,00 = 0.3125 or 31.25%
X Lever = 125,000 / 400,00 = 0.3125
X PSO = 125,000 / 400,00 = 0.3125
X Engro = 125,000 / 400,000 = 0.3125
X Loan = -100,000 / 400,000 = - 0.25
Note: Loan taken is also part of your portfolio, that is, it is also a security included in
your portfolio. But its weight is negative because by taking loan you are not
investing rather it is reverse of investing because when you invest in a stock ,
money goes out of your pocket; while in case of taking loan , money comes in your
pocket. Therefore although you have invested in 4 stocks, but in this portfolio there
are 5 securities, and this portfolio has 5 Xs; and the sum of weights would still be
ONE as it must always be the case. It is so because weights of a portfolio is
52
percentage of your OE, as your total OE is equal to 100% therefore weights of all
assets must add up to 100% or 1.
Sum of weights = ∑Xi = X ICI + X PSO + X Lever + X Engro + X Loan = 1
∑Xi = 0.3125 + 0.3125 + 0.3125 + 0.3125 + - 0.25 = 1
If you had ignored the weight of loan then adding the weights of 4 only stocks
would add up to 1.25, and that would be incorrect depiction of portfolio
construction.
Rp = ∑XiRi (whereas i can vary from ICI to Loan)
Rp = (Xici Rici ) + (Xlever RLever ) + (Xpso Rpso ) + ( Xengro Rengro ) + ( XLoan RLoan )
Rp = (0.3125 x 15%) + (0.3125 x 20%) + (0.3125 x 22%) + (0.3125 x 12%) + (-0.25 x 10%)
Rp = 19.06% / Year
Please Note: Though you invested equal amounts in 4 stocks but when portfolio
was built with some of your funds (OE) plus some borrowed fund, the return were
greater; that is 19.06% instead of 17.25% although investment was in the same 4
stocks and amount invested in each stock was equal. This additional 1.81
percentage points of Rp is called financial leverage effect: this was a levered
portfolio, and its ROR is higher (19.06%) than ROR of an all equity financed portfolio
(17.25%).
In both portfolios your own funds were 400,000, but expected Rp you hope to earn
is higher when you also borrowed 100,000 at 10% per year interest rate. Please
note expected Rp 19.06% on levered portfolio and 17.25% on all-equity portfolio is
a rate of return on your 400,000 rupees OE, so it is aROE; and it is not ROR on total
funds 500,000; so Rp is in fact an ROE because it is profits/OE as you shall see later.
This expected Rp is magnified when you used financial leverage. Also beware in
case of losses , that is stocks earning negative Ri, the all equity portfolio would have
a smaller negative Rp but levered portfolio would have a larger negative Rp. Be
warned that “financial leverage is a double edged sword”. When times are good
and stocks are expected to give positive Ri, using financial leverage (that is taking
loan and investing your funds plus borrowed funds) would magnify positive Rp of
levered portfolio compared to a portfolio built by using only your own funds. But
when times are bad and stocks give negative Ri, then your levered portfolio would
have magnified negative Rp compared to negative Rp on an a portfolio built by
using only your own funds.
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Beginning Balance Sheet of levered Portfolio discussed in this example looks like
this:
TA = TL + OE
500,000 = 100,000 + 400,000
Profit = investment * ROR
After one year when expected Rp has been realized
End OE = beginning OE + profit = 400,000 + (400,000 * 0.1906) = 400,000 + 76,240
= 476,240
End Loan = beginning loan + interest = 100,000 +(100,000 * 0.1) = 100,000 + 10,000
= 110,000, that is End TL
End TA = End TL + End OE
= 110,000 + 476,240
= 586,240
Rp = (W1 – Wo) / Wo
= (End OE – Beg OE) / Beg OE
= (476,240 - 400,000)/400,000 = 0.1906
Pleae note in portfolio context, W, wealth, refers to OE, and not to the TA of the
portfolio.
How End TA are 586,240 ?
First calculate profit on each stock
investment in a stock * ROR = Profit
ICI Rs 125,000 * 15% = 18,750
Lever Rs 125,000 * 20% = 25,000
PSO Rs 125,000 * 22% = 27,500
Engro Rs 125,000 * 12% = 15,000
Total Rs 500,000 86,250
So 500,000 invested in 4 stocks earned profit of 85,250 after one year, probably due
to increase in their price if no dividends were given by any of these 4 companies.
Therefore MV of stocks included in this portfolio ( End TA of this portfolio) at the
end of one year was 586,250.
But Rp was nor these profits / total investment = 86,250 / 500,000 = 17.3%
You already found Rp was 19.06%, so how did that come about?
Please note from this profit 86,250 earned by 4 stocks, 10,000 interest on loan has
to be paid ( note End TL are 110,000 composed of 100,000 loan plus 10,000 interest
in the End balance sheet.)
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So 86,250 – 10,000 = 76,250 is net profit that belongs to owner (that is you), and
that is why End OE has increased by this amount from 400,000 Beg OE to 476,250
End OE in the 2 balane sheets.
And Rp = net profits for owner / Beg OE = 76,250 / 400,000 = 0.1906 or 19.06%
And this Rp is ROE because profits to owners / OE gives same answer as given by
formula: Rp = ∑XiRi
of expected Rp calculated above.
Case of Short Selling:

Another method of introducing financial leverage in your portfolio.
In short selling you borrow some shares from broker and sell these to get cash.
Your funds plus funds generated by short selling equals total funds available to buy
other stocks.
Suppose you have 400,000 your own funds (OE), and decided that you would short
sell Engro shares worth 200,000 rupees, that is equal to 50% of your OE ( 400,000 x
0.5 = 200,000)
Now total cash available = 400,000 + 200,000

= Equity + Loan (debt)
= Rs 600,000
You decided to invest 600,000 equally in 3 stocks i.e. ICI, Lever and PSO, thus
dividing total funds in to 3 stocks gives 600,000/ 3 = Rs 200,000 invested in each
stock. Note that weights of this levered portfolio are:
Xi = investment in a stock / your OE
So XICI = 200,000 / 400,000 = 0.5
XLever = 200,000 / 400,000 = 0.5
XPSO = 200,000 / 400,000 = 0.5
XEngro = -200,000 / 400,000 = - 0.5
Note: Negative weight (X) for Engro means you have short position in Engro; while
positive weights of other 3 stocks means long position in those shares. Construction
of this portfolio was done by using 4 stocks, 3 have positive weights, and one has
negative weight , but sum of weights must always be 1. You have long position in 3
stocks and short position in one stock.
∑Xi = X ICI + X PSO + X Lever + X Engro
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∑Xi = 0.5 + 0.5 + 0.5 + - 0.5

∑Xi = 1
Expected Rp = ∑XiRi
Expected Rp = (Xici Rici ) + (Xlever RLever ) + (Xpso Rpso ) + ( Xengro Rengro )
Expected Rp= (0.5 x 15%) + (0.5 x 20%) + (0.5 x 22% + (-0.5 x 12% )
Expected Rp = 7.5% + 10% + 11% - 6%
Expected Rp = 22.5%
Please note expected Rp on this levered portfolio is higher than expected ROR of an
all equity financed portfolio which shown above was expected to give 17.25% ROR.
Please note none of the 4 stocks used to construct this portfolio has expected ROR
as high as 22.5% but the portfolio built by using these low return stocks can be
expected to give such a high Rp. This is the power of portfolio that by using
financial leverage you can build a portfolio whose expected Rp is greater than the
expected Ri of stocks included in that portfolio. This was also a levered portfolio;
its expected Rp is higher compared to the case when only your funds were equally
invested in these 4 stocks (17.25% as shown above).
Balance sheet of this levered portfolio at the beginning
TA = TL + OE
60,000 = 20,000 + 40,000
TL of 200,000 refers to shares of Engro that you borrowed and then short sold for
200,000 rupees, and it is a loan that has to be repaid. TA of 600,000 refer to value
of shares of the other 3 companies in which you have invested in the beginning.
As home work exercise prepare Ending Balance sheet after one year
showing
End TA = End TL + End OE
And show Rp of 22.5% was = (W1 – Wo)/ Wo , that is (End OE - Beg OE) / Beg OE
Smart and Not So Smart Short Selling

An interesting question faced by investors is to decide which stocks to short sell if
all stocks are expected to give positive Ri next year. Suppose you are making
portfolios by using only 2 stocks, stock a and stock b.
STOCKS Expected ROR
a 10%
b 5%
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You have built 5 different portfolios using these 2 stocks as shown below:
Portfolios Xa Xb
1 0.5 0.5
2 0.25 0.75
3 0 1
4 -0.25 1.25 (Short sold asset a)
5 1.25 -0.25 (Short sold asset b)
Let us now calculate expected ROR on each of the portfolio from portfolio 1 to
portfolio 5.
Rp1 = Xa Ra + Xb Rb
= (0.5 x 10%) + (0.5 x 5%)
= 7.5%
Rp2 = (0.25 x 10%) + (0.75 x 5%)
= 6.25%
Rp3 = (0 x 10%) + (1 x 5%)
= 5%
Rp4 = (-0.25 x 10%) + (1.25 x 5%)
= 3.75%
Rp5 = (1.25 x 10%) + (-0.25 x 5%)
= 11.25%
Please note: Portfolio 5 is expected to give highest returns and this was the case
where you have shorted the stock with a lower return (that is stock b) and invested
all the money, that is, your OE plus the funds raised by shorting, in the stock that is
expected to give a higher ROR (stock a).
Your expected return is lowest in case of portfolio 4, where you have shorted the
stock that is expected to give a higher ROR (stock a) and invested your OE plus
funds generated by short selling in the stock expected to give a lower ROR that is
stock b.
Lesson: Short sell the stock which is expected to give low or negative ROR and go
long (that is buy) that stock which is expected to give higher ROR to build a high
return portfolio.
Exercise
Your portfolio has 4 assets.
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Note: P1 is expected price after one year, Po is current price. You invested your own
funds (that is no loans taken) in four stocks in a manner shown below to build a
portfolio.
Stocks No of Shears Po P1 Expected DPS
a 100 50 60 0
b 200 35 40` 2
c 50 25 50 5
d 100 100 110 1
Find
1) Expected ROR (Ri) on each stock and Expected Rp of portfolio
2) If your expectations about next year’s price and dividends prove correct then
realized Rp at the end of the year would be same as the Rp you expected at the
beginning of the year.
Show realized Rp = (W1 - Wo) / Wo; do not for get W refers to OE
3) Show realized Rp = Profits / your Beg OE , that is ROE
Solution:
Expected ROR on any stock is capital gains yield + dividends yield
(𝑃1 − 𝑃0 ) 𝐷𝑃𝑆1
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑅𝑂𝑅 𝑜𝑓 𝑎 𝑆𝑡𝑜𝑐𝑘 = +
𝑃0 𝑃0
Ra = (P1 – P0 )/ P0 + (DPS1 / Po) = (60 – 50) / 50 + 0/50 = 20%
Rb = (40 – 35) / 35 + 2/35 = 19.99% use 20 %
Rc = ( 50 – 25) / 25 + 5/25 = 120%
Rd = (110 – 100) / 100 + 1/100 = 11%
Amount invested in each stock at the beginning of the year is = Po x Number of
shares, so investment in:
Stock a = Rs 50 x 100 = 5,000
Stock b = Rs 35 x 200 = 7,000
Stock c = Rs 25 x 50 = 1,250
Stock d = Rs 100 x 100 = 10,000
Total amount invested = 5000 + 7000 + 1250 + 10,000
= 23,250. This is W0
Now calculate weights (Xs) of this portfolio:
Xi = Amount invested in a stock / OE
Xa = 5,000/23,250 = 0.215
Xb = 7,000 / 23,250 = 0.301
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Xc = 1,250 / 23,250 = 0.0537

Xd = 10,000 / 23,250 = 0.4303
Note Sum of Xi is one or 100%, so: 0.215 + 0.301 + 0.0537 + 0.4303 = 1
Expected Rp = ∑ Xi Ri
Rp = (Xa * Ra) + (Xb * Rb) + (Xc * Rc) + (Xd * Rd)
Rp = (0.215*20%) + (0.301* 20%) + (0.0537 * 120%) + (0.4303*11%)
= 4.3% + 6.02% + 6.44% + 4.73%
= 21.47%
Value of your investment in each stock at the end of one year (W1) is:
no of shares multiplied by price after one year plus dividends received
(No of shares x P1 ) + (no of shares * DPS) = wealth after 1 year
Stock a: (100 * Rs 60) + (100 * Rs 0) = 6,000 or W0(1 + Ra) = 5,000(1 + 0.2)= 6,000
Stock b: (200 * 40 Rs) + (200 * 2 Rs) = 8,400
Stock c: (50 * 50) + (50 * 5) = 2,750
Stock d: (100 * 110) + (100 * 1) = 11,100
total value of shares in your portfolio plus cash received as dividends at the end of
the year = 6,000 + 8,400 + 2,750 + 11,100 = Rs 28,250. This is W1
Realized Rp = (W1 – Wo) / Wo
= ( 28,250 – 23,256) / 23,256
= 21.47%, same as you estimated above
Realized Profits = Wealth at the end(W1) – Wealth at beginning(Wo)
=28,250 – 23,256
= 4,994 almost 5,000
Realized Rp =Profit / Beg OE
=4,994/23,250
=21.47% , same as above
Note that if your expectation about next year’s share price and cash dividends come
true then your realized Rp turns out to be same as the Rp expected by you at the
beginning of the year.
Balance sheet of portfolio at the beginning :
TA = TL + OE
23, 250 = 0 + 23, 250
TA of 23,250 are in the form of shares of companies a, b, c, and d
Balance sheet of the portfolio at the end of one year
TA = TL + OE
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28,250 = 0 + 28,250
TA of 28,250 are in the form of shares of companies a, b, c, and the cash dividends
received during the year. If you decide to liquidate your portfolio at this time then
you can sell these shares and have cash equal to 28,250 rupees. Please note in
these exercises broker’s commission has been ignored.
Please note total profit on this portfolio is equal to sum of the profits earned from
each share
Profit from stock a = W1 - W0 = 6,000 - 5,000 =1,000
Profit from stock b = 8,400 - 7,000 = 1,400
Profit from stock c = 2,750 – 1,250 =1500
Profit from stock d = 11,100 - 10,000 = 1,100
Total profits = 1,000 + 1,400 + 1,500 + 1,100 = 5,000 the same as you calculated
above. Please note:
End OE – Beg OE = Profit
28,250 - 23,250 = 5,000
Rp = ROE = Profit / Beg OE = 5,000 / 23,250 = 21.47%, as found earlier.
Building Portfolio of 2 Stocks For Target ROR

In this example the power of the concept of portfolio is demonstrated. The
example shows that there are infinite ways of combining 2 stocks o build an infinite,
therefore theoretically there are infinite number of portfolios that you can build by
investing only in 2 stocks. It further shows that you can build a 2-stock portfolio for
any target expected Rp if short selling is allowed.
Example:
Suppose there are only 2 stocks in the country 1, 2. Also assume that short selling
in allowed. Expected annual rate of return on stock 1 is 10% and on stock 2 is 5%.
You have only 10,000 of your funds.
Required:
You have 10,000 Rs of your own funds. Please build a portfolio with Expected Rp =
400% per year, and in the process find weights of 2 stocks in your portfolio, amount
invested in each stock, profits from each stock and profit expected from portfolio
after one year
Solution
First find Weights of this portfolio
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We know: Rp = X1R1 + X2R2

And ∑Xi = 1 Always.
Enter data: 400% = (X1 x 10%) + (X2 x 5%)
Since : X1 + X2 = 1
So X1 can be written as 1 – X2
Enter this expression for X1 in expected Rp equation
400% = [(1 - X2) x 10%] + (X2 x 5%)
400% = 10% - X210% + X2 5%
400% - 10% = -X2 5%
390% = - X2 5%
390% / 5% = - X2
78 = -X2
-78 = X2
Negative weight for stock 2 means short selling stock 2; and weight itself is more
than one that means more than your own OE, in fact 78 times more than your own
OE in this case.
X1 = 1 - X2
= 1- -78
= 79
Double Check Sum of Xi is One
∑Xi = X1 + X2
= 79 + (-78)
=1
Investment in each stock

You found already X1 & X2
X1 = Investment in stock 1 / Your OE
79 = Investment in stock 1 / 10,000
79 * 10,000 = Investment in stock 1
790,000 = Investment in stock 1
X2 = Investment in stock 2 / your OE
-78= Investment in stock 2/ 10,000
-78 * 10,000 = Investment in stock 2
-780,000 = investment in stock 2
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Note: negative investment means short sell stock 2 to raise 780,000 rupees and that
amount plus your 10,000 add up to total 790,000 , and that amount is invested in
stock1
Balance Sheet of portfolio at the beginning
TA = TL + OE
790,000 = 780,000 + 10,000
Expected Profits from each stock and profits from portfolio

Rupee Profits on Stock 1 & Stock 2 & Portfolio, also show that :
Expected Rp = Profits / Your equity investment
Expected Profit = Investment * expected ROR

Expected Profit on Stock 1 = 790,000 * 10% = 79,000 Rs
Expected Profit on Stock 2 = -780,000 * 5% = -39,000 Rs
Expected Profit on Portfolio= sum of profits from the 2 stocks
= 79,000 – 39,000 = 40,000 Rs
If the expected returns of 10% and 5% are actually realized on the 2 stocks by the
end of the year, then this profit would also be actually realized profits, and realized
ROR of portfolio can be worked out as:
Realized Rp = (Profits / Your OE) x 100
Rp = ( 40,000 / 10,000) x 100
= 4 x 100 = 400%
And therefore realized Rp at the end of the year would be same as the expected Rp
in the beginning of the year.
You can use expected Rp formula to calculate realized Rp if expected RORs on the 2
stocks were actually realized by the end of the year, and if there was no change in
the composition of your portfolio during the year, that is, weights of stock 1 and
stock 2 were not changed during the year:
Expected Rp = ∑XiRi = X1R1 + X2R2
= (79*10%) + (-78* 5%)
= 790% - 390%
= 400%
Another Example of building portfolio for a target expected Rp
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Using the same 2 stocks build a portfolio with target expected Rp of 7% per year.
And it means work out the weights of the stock 1 and stock 2, and tell how much of
your 10,000 OE would you invest in each of the 2 stocks, what would be your
expected profit from such a portfolio, in which stock you would take long position
and in which stock short position?
Rp = X1R1 + X2R2
Enter data:
7% = (X1 x 10%) + (X2 x 5%)
Since : X1 + X2 = 1
So X1 can be written as 1 – X2
Enter this expression for X1 in expected Rp equation
7% = [(1 - X2) x 10%] + (X2 x 5%)
7% = 10% - X210% + X2 5%
7% - 10% = -X2 5%
-3% = - X2 5%
-3% / 5% = - X2
-0.6 = -X2
0.6 = X2
X1 = 1 - X2
= 1- 0.6
= 0.4
Sum of weights = X1 + X2 = 0.4 + 0.6 = 1
As both weights are positive so you would take long position in both stocks.
Investment in stock 1 / OE = X1
Investment in stock 1= X1 * OE = 0.4 * 10,000 = 4,000
Investment in stock 2 / OE = X2
Investment in stock 1= X1 * OE = 0.6 * 10,000 = 6,000
Expected profits from stock1 = investment * expected ROR = 4,000 * 10% = 400
Expected profits from stock 2 = investment * expected ROR = 6,000 * 5% = 300
Total expected profits = 400 + 300 = 700
Double check that expected ROR is = profits / OE = 700 /10,000 = 0.07 = 7%
Expected Rp = X1R1 + X2R2
= (0.4 * 10%) + (0.6 * 5%) = 4% + 3% = 7%
Expected Rp When Stock Returns Data Are Probabilistic
63
Data on 3 stocks (A, B, and C) with the probability of expected rate of returns under
4 different economic scenario are given:
Next Year’s
Economic Expected RORs
Outcome Probability Stock A Stock B Stock C
Boom 0.3 -10% 10 0
Hi growth 0.2 0 10 10
Low growth 0.3 10 5 15
Recession 0.2 20 10 5%
Find
1) Expected Rp if you built a portfolio by investing 20% of your equity in stock A; 50%
of your equity in stock B; and 30% of your equity in stock C. It means weights of
your portfolio are: Xa = 0.20 ; Xb = 0.50 and Xc = 0.30.
Please note that sum of weights (Xi ) fo this portfolio is: 0.2 + 0.5 + 0.3 = 1, as it
MUST ALWAYS BE. Also it is interesting to realize that while working with
portfolios what is important is weight (Xs), not the amount invested while
calculating returns of portfolio; and as you shall see later in the course the same is
true about risk of portfolio, it is the weights of stocks not the amount invested
which matter. In other words, it does not matter if you were a rich or a poor
person; it does not matter if your OE was 5,000 rupees or 50 million rupees. Your
portfolio would earn a percentage ROR based upon the division of your OE into
different stocks and that is called weights of different stocks in your portfolio, and is
symbolized here as Xs of portfolio.
Solution: Using probabilities you can find on each stock expected ROR as shown
below
Expected Ri = (ROR(boom) * Prob) + (ROR (HI g) * Prob) + (ROR(Lo g)* Prob) + (ROR(Recession) * Prob)
Expected Ra = (-10% x .3) + (0% x .2) + (10% x .3) + (20% x .2) = 4%

Expected Rb = (10% x .3) + (10% x .2) + (5% x .3) + (10% x .2) = 8.5%
Expected Rc = (0% x .3) + (10% x .2) + (15% x .3) + (5% x .2) = 7.5%
Now using expected ROR of stocks you can find expected ROR of portfolio
Expected Rp = XaRa + XbRb + XCRC
= (0.2*4) + (0.5*8.5) + (0.3*7.5)
=7.3%
Another Method: There is another way of looking at this data; you can estimate
directly expected Rp of this portfolio under each of the 4 different economic
64
scenarios by using stocks return data under each economic scenario likely to prevail
next year, as shown below:
1st line:
Rp (Boom) = XaRa + XbRb + XcRc
= (0.2 x -10) + (0.5 x 10) + (0.3x0)
= 3%
Rp(Boom) = 3% and its Probability = 0.3
This means that there a 3% rate of return is expected to be given by this portfolio if
during the next year economy is booming, and chance of the booming economy, as
given in the data set, is 30%.
2nd line:
Rp (Hi g) = (0.2 x 0%) + (0.5 x 5%) + (0.3x15%)
Rp(Hi g) = 8%
Probability of high economic growth , as given in the data, is 0.2
3rd line:
Rp(Low g) = (0.2 x 10%) + (0.5 x 5%) + (0.3x15%)
Rp(Low g) = 9%
Probability = 0.3
4th line:
Rp(Recession) = (0.2 x 20%) + (0.5 x 10%) + (0.3x5%)
= 10.5%
Probability = 0.2
Expected Rp = (Rp(boom) x Prob) + (Rp(Hi g) x Prob) + (Rp(Lo g) x Prob) + (Rp(Recession) x
Prob)
= (3% x 0.3) + (8% x 0.2) + (9% x 0.3) + (10.5 x 0.2)
= 0.9 + 1.6 + 2.7 + 2.1
Expected Rp = 7.3%
Please note it is the same expected Rp as calculated above.
Home Work Exercise
65
The following stocks interest you and you have done security analysis of these
companies ; you have estimated as follows:
Stocks P0 DPS0 growth rate Shares Position
Engro 300 10 10% 200 Long
PSO 1,200 18 6% 100 Long
SUI Gas 30 3 - 10% 1,000 Short
Required:
Please estimate : 1) next year DPS of each stock; 2) next year share Price of each
stock; 3) expected ROR of each stock; 4) Your own funds (OE) needed to be invested
in the beginning to build this portfolio ; 5) borrowed funds, debt or TL, used to build
this portfolio at the beginning; 6) total funds invested in the portfolio at the
beginning (TA); 7) Weights (Xs) of your portfolio; 8) expected Rp of your portfolio;
9) Wealth (shares * price) initially invested in each stock, note for shorted stock
this amount should be negative; 10) Wealth in each stock after one year, that
would be estimated as W1 = W0(1 + expected ROR); 11) TA of portfolio at the end
of the year assuming expected RORs on each stock would be realized; 12) TL of this
portfolio at the at the end (please do not forget that on short sold stocks you have
to pay dividends to the party from whom you borrowed along with buying these
shares at the end of the year on the price you expect and then returning same to
that party at the end of the year); 13) Your Wealth (OE) in the portfolio at the end
of the year, note: TA – TL = OE; 14) your profits in rupees after one year, it is
increase in OE; 15) show that realized Rp = profits / your wealth in the beginning;
16) please show realized Rp = (OE at the end – OE at the beginning) / OE at the
beginning, your OE is your wealth called “W”.
1.
DPS1 = DPS0 (1 + g)
Engro =10(1 + 0.1) = 11
PSO =18(1 + 0.06) =9.08
SUI =3(1 + - 0.1) = 2.7
2.
P1 =P0(1 + g)
Engro = 300(1 + 0.1) =330
PSO = 1,200(1 + 0.06) = 1272
SUI = 30 (1 - 0.1) = 27
66
3.
Expected ROR =DPS1/P0 + (P1 - P0) /P0
Engro = 11/300 + (330 - 300)/300 =13.7%
PSO = 9.08/1,200 + (1,272 - 1,200) / 1,200 = 6.8%
SUI = 2.7/ 30 + (27 - 30) /30 = -1%
4, 5, and 6 and 9
Investment in stock= Shares * P0
Engro = 200 * 300 = 60,000
PSO = 100 * 1,200 = 120,000
SUI = 1,000 * -30 = -30,000
TA = TL + OE
180,000 = 30,000 + 150,000
So you need to invest 150,000 of your OE, while 30,000 would be raised by shorting
SUI and total 180,000 available would be invested in Engro (60,000) and PSO
(120,000).
7.
XEngro = investment / OE = 60,000 / 150,000 = 0.4
XPSO = investment / OE = 120,000 / 150,000 = 0.8
XSUI = investment / OE = - 30,000 / 150,000 = - 0.2
Sum of weights = 0.4 + 0.8 + - 0.2 = 1
8.
Expected Rp = XEngro * REngro + XPSO * R PSO + XSUI * R SUI
=(0.4 * 13.7%) + (0.8 * 6.8%) + (- 0.2 * -1%)
= 5.48% + 5.44% + 0.2%
=11.12%
Please note shorting SUI, which was expected to give negative ROR, has contributed
positively to portfolio returns by 0.2 %age points as shown above.
10.
Expected amount of wealth in the form of value of shares plus dividends recieved
after one year
W1 = W0(1 + expected ROR)
Engro = 60,000 (1 + 0.137) = 68,220
PSO = 120,000(1 + 0.068) = 128,169
SUI = -30,000 (1 – 0.01) = - 29,700
67
11, 12, and 13

TA = TL + OE
196,389 = 29,700 + 166,689
196,389 = 68,220 + 128,169, after one year this is the value of shares plus cash
dividends recieved from Engro and PSO respectively. Negative 29,700 is value of
shares of SUI plus dividends paid to broker as you had shorted shares of SUI in the
beginning of the year to build this portfolio
14 and 16
Profit = End OE - Beg OE
166,689 - 150,000 = 16,689
15.
Realized Rp = ROE = Profit / Beg OE = 16,689 / 150,000 = 11.12%
This is same as you found above in item 8 using expected Rp formula.
68

Lecture 5 & 6

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Lecture 5 & 6

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2019.

Instructor: Dr. Sohail Zafar. TA: Ms Maheen Chaudhry

Return on Standalone Stock

= 5 / 200 + ( 250 - 200)/200

On a rented house / plaza = rent income / Po + )p1 - Po)/Po

background Info about professionally Managed Portfolios

Closed ended mutual fund portfolios

A hedge fund is a highly leveraged portfolio having a balance sheet like:

Closed ended portfolio’s realized Rp

Wealth at the beginning of period (W0) is composed of number of shares of stock A

Rp1 = ( OE1 - OE0)/ OE0 = (25 - 50 )/ 50 = - 50% or 0.5

Open ended portfolio’s realized Rp

Time weighted realized Rp

2- year holding period Rp = [(1 + Rp1)*(1 + Rp 2] – 1

2-year holding period Rp = [(1 + Rp1)*(1 + Rp2)] – 1

And actual balance sheet end of year 1 is

Holding Period Realized Rp for multiple

1: W1 = Wo (1 + Rp1) = 10,000 (1+ 0.1) = Rs 11,000

Expected Return on portfolio (Rp)

whereas ‘ i ‘ can vary from stock ‘a’ to stock ‘n’.

Weights of a Portfolio Must Add to One, Sum of Xi =1

The concept of balance sheet is applicable to portfolios as well.

Exercise : Expected Rp on an equally weighted portfolio with no leverage

Stock Amount Invested Expected ROR (Ri) per year

Case of Short Selling:

Now total cash available = 400,000 + 200,000

∑Xi = 0.5 + 0.5 + 0.5 + - 0.5

Smart and Not So Smart Short Selling

Xc = 1,250 / 23,250 = 0.0537

Building Portfolio of 2 Stocks For Target ROR

We know: Rp = X1R1 + X2R2

Investment in each stock

Expected Profits from each stock and profits from portfolio

Expected Profit = Investment * expected ROR

Another Example of building portfolio for a target expected Rp

Expected Rp When Stock Returns Data Are Probabilistic

Expected Ra = (-10% x .3) + (0% x .2) + (10% x .3) + (20% x .2) = 4%

Please note it is the same expected Rp as calculated above.

Home Work Exercise

11, 12, and 13

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