Portfolio Management CA Final SFM by CA Mayank Kothari PDF

CA Final SFM | Chapter 7
PORTFOLIO
MANAGEMENT
CA MAYANK KOTHARI
28 76 56 35 106
Hours Videos Practical Questions Theory Questions Lectures Pages Notes
C A F i n a l S F M | अ ध्या य ७
पोटर्फोिलयो
प्रबंधन
सी.ए. मयंक कोठारी
28 75 56 35 106
घंटे के वीिडयो व्यावहािरक प्रश्न िसद्धांितक प्रश्न व्याख्यान पृष्ठों की पुस्तक
About The Faculty
CA Mayank Kothari
CA, BBA
Co-Founder of Conferenza.in
Achievements
1. Qualified the Chartered Accountancy exam in May 2012 held by ICAI.
2. Secured All India 47th Rank in CA Final and was topper in Nagpur division of
ICAI.
3. Also, he received Gold Medal for securing highest, 88 Marks in Indirect Tax
paper in Nagpur division.
4. He was felicitated with the Best Student Award from the hands of Vice
Chancellor of Nagpur University.
5. He has worked with Deloitte, Haskins and Sells, Pune
6. He has successfully implemented the Lightboard Technology in education
being the First in India.
7. Developed Conferenza MCQs App which has 50000+ Free MCQs for CA
Students
For support Call 8448449881 or Mail at support@Conferenza.in

Content
Question Particulars Page no.
1 What is Investing? 1
2 What are Some Types of Investments? 2
3 Are there risks associated with investing? 2
4 Explain with example how to calculate return of investment in single security or single asset 3
5 Explain with example how to calculate risk of investment in single security or single asset 5
6 Explain the components of Total Risk. Or Write a short note on Systematic and Unsystematic Risk 7
7 Distinguish between Systematic Risk and Unsystematic Risk 8
8 What is Beta? 8
9 How to calculate beta? 10
10 Explain the Concept of Coefficient of Correlation (r), Covariance (Cov), and R Squared 12
11 Write a short note on Risk – Return Trade off 14
12 Define Portfolio and Portfolio Management 15
13 Write a short note on Objectives of Portfolio Management 16
14 Explain 5 phases of Portfolio Management 17
15 Explain how to calculate Portfolio Return 20
16 Explain how to calculate Risk of Portfolio having 2 securities/assets 20
17 Explain how to calculate Risk of Portfolio having 3 securities/assets 21
18 How to calculate the portfolio beta 22
19 How to calculate proportion or weights of two securities in order to constitute a minimum variance 22
portfolio
20 Write a short note on Diversification 23
21 What are the theories in Portfolio Management 24
22 Write a short note on Modern Portfolio Theory or Write a short note on Markowitz model of Risk 24
Return Optimization
23 State the assumptions of Markowitz Model or Modern Portfolio Theory 25
24 What is Efficient Frontier? 26
25 Write a short note on Capital Asset Pricing Model 29
26 What are the assumptions of CAPM 32
27 What are the Advantages and Limitations of CAPM 32
28 How to find out if the stock is undervalued, overvalued or correctly Valued 33
29 Write a short note on Arbitrage Pricing Theory 34
30 Write a short note on Single Index Model 37
31 Write a short note on Portfolio Evaluation Measures or How to measure the performance of a 39
portfolio or security? or Write a short note on Sharpe Ratio, Treynor Ratio, Jensen’s Alpha
32 Write a short note on Sharpe’s Optimal Portfolio Theory 40
33 Write a short note on Portfolio Rebalancing Theories or Write a short note on Buy and Hold Policy or 42
Write a short note on Constant Mix Policy or Constant Ratio Plan
34 or Write a short note on Constant Proportion Portfolio Insurance 46
35 Policy (CPPI) 47
36 Make a comparative evaluation of Portfolio Rebalancing Theories 49
37 Write a short note on Short Selling 51
38 Write a short note on Market Lines 53

Question Particulars Page no.
39 Discuss Principles and Management of Hedge Funds 55
40 Explain different types of Asset Allocation Strategies 57
41 Explain the process involved in fixed income portfolio 60
42 What methods are involved to calculate the return of fixed income portfolio? 60
43 Discuss about the fixed income portfolio management strategy 63
44 What is Alternative Investment? 65
45 What are the features or characteristics of Alternative Investment? 66
46 What are the different types of Alternative Investments? 66
47 What makes the Real Estate Valuation complex? 67
48 What approaches are used for Real Estate Valuation? 67
49 What is Mezzanine Finance? 68
50 What is Venture Capital Fund? 68
51 What are the characteristics of venture capital fund? 69
52 What are the advantages of bringing venture capital into the company? 69
53 Discuss the stages of funding in Venture Capital Finance 70
54 Discuss the venture capital investment process 70
55 What is a distressed security? 72
56 What types of risk has to be analyzed before investing in distressed securities? 73
57 Practical Questions 1-75 74-106

Chapter 6 Portfolio Management
Chapter 6
Portfolio Management
Investment Basics
When you were a child, you probably kept your money in a piggy bank or some
equivalent container in your bedroom. You dropped coins or stuffed bills in the
top and then shook them out of the bottom whenever you needed a little cash. If
you put every rupee of your allowance into your bank and did not spend it, over
time you might have saved a couple of thousand rupees, but the only money inside
was money that you put in yourself.
Putting your money into a savings account at your local bank is not much different
than keeping it in a piggy bank at home. While a bank will pay you interest on the
money in your account, interest rates on savings accounts are low and the amount
of money you have will increase at a very slow rate.
Q1. What is investing?

Answer:
 Investing refers to the act of using your money to buy some sort of financial
product (or other item) in the hope and expectation that the product will
grow in value after you buy it.
 If the product does increase in value, you can sell it for a profit. Some
investments are meant to be held for a long time before they grow, such as
money you may invest now to use later when you retire.
 Other investments are more short-term; you may buy one now, hold it for
a year or less, and then sell it.
 Some people take the money they earn from these short-term investments
and reinvest the profits in another investment.
Page 1
CA Final SFM CA Mayank Kothari
Q2. What are Some Types of Investments?

Answer:
Almost anything you buy now that you think you can sell for more money
later is considered an investment, including things like real estate,
collectibles, stocks and bonds.
 A stock is a share of ownership in a company. The value of a share of stock
fluctuates daily based on the company’s earnings, profit potential, the
general economy and other factors. People who invest in the stock market
generally buy shares in a number of different companies and hold them for
a long time. Dividend received and the capital appreciation in the
investment is the return to the shareholder.
 A mutual fund is a group of stocks that is selected and managed by a
professional money manager. Investors buy shares in the mutual fund and
the manager has task of buying and selling the individual stocks in the fund
to try to make the overall value of the fund grow.
 A bond is a financial product that you buy at a set price, hold for a specific
period of time, and then redeem at the bond’s maturity rate for a gain, which
is set by the terms of the bond. Bonds may pay periodic interest during their
lifetime or may only pay out at the end.
Q3. Are there risks associated with investing?

Answer:
 Almost all investments carry some risk that the product or item will lose
value instead of gain over time. Some investments, such as bonds, are very
low risk because they have set terms governing their payout. Buying
individual stocks is more risky because their value depends on the
volatility of the stock market, which is very difficult to predict.
 Mutual funds are somewhere in between, depending on the fund and the
type of stocks in it. Generally, riskier investments have a greater potential
for growth or loss. Low-risk investments do not earn the investor as much
money but the money they do earn is predictable and secure.
You're Never Too Old to Start Investing
Page 2
One of the most important things you can do to ensure your financial fitness
is to just start investing – now! Don’t wait because time is not in your favour.
Many people think you need a lot to start investing, but you can invest as a
little as `500/- per month.
It’s important to understand the difference between savings and investing.
Saving money won’t make you rich, but it will be there when you need it.
Savings are when you put your money in savings accounts, certificate of
deposits, money market accounts, etc. Investing involves more risk, but if you
make good investment decisions, your investments will yield higher returns
over time than savings. Investing is when you put your money in stocks,
mutual funds, bonds, etc.
Q4. Explain with example how to calculate return of investment in single

security or single asset.
Answer:
Let’s take an example of purchase of a share. With an investment in equity share,
an investor expects to receive future dividends declared by the company. In
addition he expects to receive capital gain in the form of difference between the
selling price and the purchase price when the share is finally sold.
Suppose a share of X Ltd. is currently selling at `12.00. An investor who is
interested in share anticipates that the company will pay a dividend of `0.50 in
the next year. Moreover he expects to sell a share at `17.50 after one year. The
expected return from the investment in share will be as follows:
Forecasted Dividend + Forecasted Capital Appreciation
R=
Initial Investment
0.50 + (17.50 − 12.00)

R= = 0.50 i. e. 50%
12.00
It is important to note that here the investor expects to get a return of 50% in the
future, which is uncertain. It might be possible that the dividend declared by the
company turn out to be either more or less than the figure anticipated by the
investor.
Page 3
Similarly the actual selling price of the share may be less than the price expected
by the investor (`17.50) at the time of investment. It may sometimes be even
more. Hence there is a possibility that the future return may be more or less than
50%.
Since the future is uncertain the investor has to consider the probability of several
other possible returns. Investor now has to assign the probability to the various
possible returns as follows:
Possible Returns (%) Probability of occurrence
20 0.20
30 0.20
50 0.40
60 0.10
70 0.10
With the help of the past data investor can make such type of distribution of
returns. Now with the help of this data we can calculate Expected Return
1. Expected Return: The expected return of the investment is the probability
weighted average of all the possible returns.
𝐧
̅ = ∑ 𝐑 𝐢 𝐏𝐢
𝐑
𝐢=𝟏
Where,
The possible returns are denoted by 𝐑 𝐢 and
The related probabilities by 𝐏𝐢
Expected return 𝐑̅
Return Probability Expected Return
[𝐑 𝐢 ] [𝐩𝐢 ] [𝐑 𝐢 𝐩𝐢 ]
20 0.20 4
30 0.20 6
50 0.40 20
60 0.10 6
70 0.10 7
Total ∑ R i 𝑃i 43%
Page 4
Summary Class Notes

Single Security/ Asset Return
Without Probability With Probability
Q5. Explain with example how to calculate risk of investment in single

security or single asset.
Answer:
 The possibility of variation between expected return and actual return
from an investment is known as risk.
 The most popular measure of risk is the Variance (σ2 ) or Standard
Deviation (σ).
 An investment whose returns are fairly stable is known as a low risk
investment. E.g. Government securities. An investment whose returns
fluctuate significantly is known as a high risk investment. E.g. Equity
shares.
Steps to calculate Standard Deviation
- Calculate the expected (weighted average) return from the given data
[43% as calculated above]
- Now add one more column and calculate deviation of each possible
return from expected return [like 20-17.41=2.59]. You will find some
values with +ve signs as well as - ve signs
- Risk of say 10%, itself means the possibility of up or down movements
of the expected returns by 10%. We never say that the risk is negative
10% (-10%). Hence to remove the negative effects in the above step add
one more column and square out each deviation calculated above
[2.592 = 6.708].
- Remember that we will compensate this extra step of squaring by
calculating the square root again before our final answer.
Page 5
- As you have calculated the squares of each deviation now multiply it

with the respective probabilities and sum it up in the last row, this will
give you the value of variance.
- Apply square root in order to find out the Standard Deviation.
Considering the same problem as discussed in Q4 and calculate the risk.
Solution:
Expected
Return Probability Deviation Product
Return
Ri Pi ̅
Ri − R ̅)²Pi
(R i − R
̅
R
20 0.2 4 -23 105.8
30 0.2 6 -13 33.8
50 0.4 20 7 19.6
60 0.1 6 17 28.9
70 0.1 7 27 72.9
20 0.2 4 -23 105.8
Total 43 Varianceσ2 261
Standard Deviation 𝝈 16.16 %
Notes:
 The basic purpose to calculate the variance and standard deviation is to
measure the extent of variability of possible returns from the expected return.
The method described above is widely used for assessing the risk and is also
known as the mean variance approach.
 However, Standard Deviation or Variance is a measure of Total Risk and
total risk has two components: systematic risk and unsystematic risk.
𝐓𝐨𝐭𝐚𝐥 𝐑𝐢𝐬𝐤 = 𝐒𝐲𝐬𝐭𝐞𝐦𝐚𝐭𝐢𝐜 𝐑𝐢𝐬𝐤 + 𝐔𝐧𝐬𝐲𝐬𝐭𝐞𝐦𝐚𝐭𝐢𝐜 𝐑𝐢𝐬𝐤
Page 6
Q6. Explain the components of Total Risk. Or Write a short note on

Systematic and Unsystematic Risk.
Answer:
Systematic Risk [β]: Systematic risk is the risk of the entire market segment
Conversely some event can affect all the companies at the same time; this being
the systematic risk includes occurrences as inflation, war, fluctuating interest rate
– generally those events that influence the entire economy.
 Of course diversification cannot eliminate the likelihood of happening of
these events.
 Systematic risk accounts for most of the risk in diversified portfolios. And
in exchange of this risk investors may be rewarded in terms of returns on
their investment.
Unsystematic Risk: Unsystematic risk is the risk specific to the company.

 Often a risk that involves some kind of dramatic event such as a strike, fire
etc. is termed as unsystematic risk.
 Diversification among the stocks of many companies reduces unsystematic
risk because of course it’s highly unlikely that every one of the unhappy
events listed above will occur in all companies at the same time.
 Risk associated with a security of particular company can be eliminated/
reduced through diversification.
 But there is no reward for taking unsystematic risk as it is believed that the
same can be eliminated through a diversification
Page 7
Q7. Distinguish between Systematic Risk and Unsystematic Risk.

Answer:
Particulars Systematic Risk Unsystematic Risk
Meaning Risk inherent to the entire market or Risk inherent to the specific
entire market segment. company or industry.
Control Uncontrollable by an organisation Controllable by an organisation
Nature Macro in nature Micro in nature
Types Interest rate risk, market risk, Business/Liquidity risk,
purchasing power / inflationary risk financial/credit risk
Also known Market risk, Non diversifiable risk Diversifiable risk
as
Example Recession and wars all represent Sudden strike by the employees of a
sources of systematic risk because they company you have shares in, is
affect the entire market and cannot be considered to be unsystematic risk.
avoided through diversification.
So in short what matters the most to the investor is to know the systematic risk of
his investment. Systematic risk is measured by a statistical measure called BETA.
Q8. What is Beta?

Answer:
 How should investors assess risk in the stocks they buy or sell? As you can
imagine, the concept of risk is hard to pin down and factor into stock
analysis and valuation. Is there a rating - some sort of number, letter or
phrase - that will do the trick?
 One of the most popular indicators of risk is a statistical measure called
BETA. Stock analysts use this measure all the time to get a sense of stocks'
risk profiles.
 In finance, the beta (β) of a stock or portfolio is a number describing how
the return of an asset is predicted by a benchmark. This benchmark is
generally the overall financial market and is often estimated via the use of
representative indices, such as the S&P 500, Sensex, Nifty etc.
Betameasures systematic risk based on how returns co-move with the
overall market.
 Beta is a measure of a stock's volatility in relation to the market. By
definition, the market has a beta of 1.0, and individual stocks are ranked
Page 8
according to how much they deviate from the market. A stock that swings
more than the market over time has a beta above 1.0. If a stock moves less
than the market, the stock's beta is less than 1.0. High-beta stocks are
supposed to be riskier but provide a potential for higher returns; low-beta
stocks pose less risk but also lower returns.
 Thus if a stock has a beta of 1.2 and the market is expected to move up by
10 per cent, the stock should move by 12 per cent (obtained as 1.2
multiplied by 10). Similarly if the market loses ten per cent, the fund should
lose 12 per cent (obtained as 1.2 multiplied by minus 10)
Extreme and interesting cases of beta
 Beta has no upper or lower bound, and betas as large as 3 or 4 will occur with
highly volatile stocks.
 Beta can be zero. Some zero-beta assets are risk-free, such as treasury bonds
and cash. However, simply because a beta is zero does not mean that it is risk-
free. A beta can be zero simply because the correlation between that item's
returns and the market's returns is zero. An example would be betting on horse
racing. The correlation with the market will be zero, but it is certainly not a risk-
free endeavor.
 Beta is used as a hedge ratio and you will understand more about it in the
chapter Derivatives.
Value of Beta Interpretation Example
β<0 Asset generally moves in the Gold, which often moves opposite
opposite direction as compared to the movements of the stock
to the index market
β=0 Movement of the asset is Fixed-yield asset, whose growth is
uncorrelated with the movement unrelated to the movement of the
of the benchmark stock market
0<β<1 Movement of the asset is Stable, "staple" stock such as a
generally in the same direction company that makes soap. Moves
as, but less than the movement ofin the same direction as the market
the benchmark at large, but less susceptible to day-
to-day fluctuation.
β=1 Movement of the asset is A representative stock or a stock
generally in the same direction that is a strong contributor to the
as, and about the same amount as index itself.
the movement of the benchmark
β>1 Movement of the asset is Volatile stock, such as a tech stock,
generally in the same direction or stocks which are very strongly
as, but more than the movement influenced by day-to-day market
of the benchmark news.
Page 9
Q9. How to calculate beta?

Answer: Remember the beta of any security is calculated as against the Market
Returns. Therefore, one of the two components in the formula has to be market
returns
There are two methods to calculate beta
1. Regression Analysis
∑ XY − nX̅ ̅
Y
βx =
∑ Y² − nY̅²
Where,
βx = Beta of the stock x
X = Return(%)from the stock,
Y = Return(%) from the market
̅ = Expected or Mean value of returns from stock
X
̅ = Expected or Mean value of returns from market
Y
n = number of observation
2. Correlation Analysis
Corrxy σx σy Corrxy σx Covxy
βx = or or
σ2y σy σy 2
Where,
βx = beta of the stock x
Corrxy = correlation between returns of the stock and returns of the market
σx = standard deviation of returns of the stock i
σy = standard deviation of returns of the market index
σ2y = variance of the market index
Covxy = Covariance of stock x and y
Page 10
Concept Problem
Return of the security X and Market M is given below. You are required to
calculate the expected return, and beta for the security using Regression Analysis.
Return %
Security (X) Market (Y)
20 5
30 30
50 20
60 15
70 -20
20 25
Solution: Using Regression Analysis
Security
(X) Market (Y) XY Y²
20 21 420 441
30 25 750 625
50 30 1500 900
60 45 2700 2025
70 60 4200 3600
9570 7591
20 + 30 + 50 + 60 + 70
̅
X= = 46
5
21 + 25 + 30 + 45 + 60
̅ =
M = 36.20
5
∑ XY − nX̅̅Y
Beta β =
̅²
∑ Y² − nY
9570 − 5 x 46 x 36.20
=
7591 − 5 x 36.202
9570 − 8326
=
7591 − 6552
1244
=
1039
= 1.20
Page 11
Beta of +1.20 indicates that the security will move in direction with the market to
the extent of 1.20 times or 120%. Means if the market goes up by 10% , security
returns will move up by 12%. Same is when the market goes down.
Using Correlation Analysis
Returns %
Security(X) Market(M) (X − ̅ X)2 (M − M̅ )2
20 21 676 231.04
30 25 256 125.44
50 30 16 38.44
60 45 196 77.44
70 60 576 566.44
46 36.2 1720 1038.80
̅
X = 46 M̅ = 36.20 1720 1038.80
1720
SD of X, 𝜎𝑥 = √Variance = √ = 18.55
5
1038.80
SD of M, 𝜎𝑚 = √Variance = √ = 14.41
5
Corrim σi σm 0.93 x 18.55 x 14.41

βi = = = 1.20
σ2m 207.76
Q10. Explain the Concept of Coefficient of Correlation (r), Covariance

(Cov), and R Squared
Answer:
1. Covariance: Covariance indicates how two variables are related. A positive
covariance means the variables are positively related, while a negative
covariance means the variables are inversely related. The formula for
calculating covariance is shown below.
̅̅̅̅𝐚 ][𝐑 𝐛 − 𝐑
∑[𝐑 𝐚 − 𝐑 ̅̅̅̅𝐛 ]
𝐂𝐨𝐯 𝐚𝐛 =
𝐍
Where,
𝐂𝐨𝐯 𝐚𝐛 = Covariance between a and b
𝐑 𝐚 = Return on stock a
𝐑 𝐛 = Return on stock b
Page 12
̅̅̅̅𝐚 = Expected or mean return on stock a

𝐑
̅̅̅̅𝐛 = Expected or mean return on stock b
𝐑
2. Coefficient of Correlation(r): Correlation is another way to determine how two
variables are related. The Correlation Coefficient is a statistical measure that
reflects the correlation between two securities. In other words, this statistic tells
us how closely one security is related to the other.
1. The Correlation Coefficient is positive when both securities move in the
same direction, up or down.
2. The Correlation Coefficient is negative when the two securities move in
opposite directions.
Determining the relationship between two securities is useful for analyzing inter-
market relationships, sector/stock relationships and sector/market
relationships. This indicator can also help investors diversify by identifying
securities with a low or negative correlation to the stock market.
The correlation of a variable with itself is always 1[Corr. of X and X, Y and Y etc is
1]
Coefficient of correlation is calculated by dividing covariance of the two variables
by the product of standard deviation of those two variables.
𝐂𝐨𝐯𝐚𝐛
𝐫𝐚𝐛 =
𝛔𝐚 𝛔𝐛
You will always talk about correlation as a range between -1 and 1.

For example, if you say that two items have a correlation of 0.9 you are saying
that a change in one item results in a 90% change to another item. All the stock
market indexes tend to move together in similar directions. When the DOW
Jones loses 5%, the S&P 500 usually loses around 5%. When the DOW Jones gains
5%, the S&P 500 usually gains around 5% because they are highly correlated.
There could also be negative correlation where you might observe that as the
DOW Jones loses 5% of it value, Gold might gain 5%. Alternatively, if the Dow
Jones gains 5% of its value, Gold may lose 5% of its value.
3. Coefficient of Determination – R-Square 𝑹𝟐 :
 The problem is that beta depends on the index used to calculate it. It can
happen that the index bears no correlation with the movements in the
fund. Thus if beta is calculated for large cap fund against a mid-cap index,
the resulting value will have no meaning. This is because the fund will not
move in tandem with the index.
Page 13
 Due to this reason, it is essential to take a look at a statistical value called

R-squared along with beta. The R-squared value shows how reliable the
beta number is. It varies between 0 and 1. An R-squared value of one
indicates perfect correlation with the index. Thus, an index fund investing
in the Sensex should have an R-squared value of one when compared to the
Sensex. For equity diversified funds, an R-squared value greater than 0.8 is
generally accepted to mean that the underlying beta value is reliable and
can be used for the fund.
 Beta and R-squared should thus be used together when examining a fund's
risk profile. They are as inseparable as risk and return.
Q11. Write a short note on Risk – Return Trade off

Answer:
 The expression “risk–return trade-off” refers to the positive relationship
between expected risk and return. In other words, a higher return is not
possible to attain in efficient markets and over long periods of time without
accepting higher risk. Expected returns should be greater for assets with
greater risk.
 It’s crucial to keep in mind that higher risk does NOT equal greater return.
The risk/return tradeoff only indicates that higher risk levels are associated
with the possibility of higher returns, but nothing is guaranteed. At the same
time, higher risk also means higher potential losses on an investment.
 On the safe side of the spectrum, the risk-free rate of return is represented
by the return on U.S. Government Securities, as their chance of default is
essentially zero. Thus, if the risk-free rate is 6% at any given time, for
Page 14
instance, this means that investors can earn 6% per year on their assets,
essentially without risking anything.

 While a 6% return might sound good, it pales compared to returns of many
popular investment vehicles. If index funds average about 12% per year
over the long run, why would someone prefer to invest in U.S. Government
Securities? One explanation is that index funds, while safe compared to
most investment vehicles, are still associated with some level of risk. An
index fund which represents the entire market carries risk, and thus, the
return for any given index fund may be -5% for one year, 25% for the
following year, etc. The risk to the investor, particularly on a shorter
timescale, is higher, as is volatility. Comparing index funds to government
securities, we call the addition return the risk premium, which in our
example is 6% (12%-6%).
Q12. Define Portfolio and Portfolio Management

Answer:
Investing all your money in single stock? Consider, for example, an investment
that consists of only stock issued by a single company. If that company's stock
suffers a serious downturn, your portfolio will sustain the full brunt of the decline.
By splitting your investment between the stocks from two different companies,
you can reduce the potential risk to your portfolio.
Portfolio: A collection of financial assets such as stocks, bonds, mutual funds,
cash equivalents held by investors or/and managed by professionals.
Example:
1) A library is a portfolio of different kind of books.
2) Your mobile phone is a portfolio of different apps.
Portfolio Management (PM) is the procedure of selecting best available
securities which will provide the rate of return expected by the investor for any
given degree of risk and also to mitigate the risk.
Page 15
Q13. Write a short note on Objectives of Portfolio Management

Answer:
1. Security of the Principal Investment
Portfolio management not only involves keeping the investment intact but
also contributes towards the growth of its purchasing power over the period.
The motive of a financial portfolio management is to ensure that the
investment is absolutely safe.
2. Consistency of returns ( Stability of Income)
Portfolio management also ensures to provide the stability of returns by
reinvesting the sa me earned returns in profitable and good portfolios.
3. Risk reduction ( Diversification)
Portfolio management is purposely designed to reduce the risk of loss of
capital and/or income by investing in different types of securities available
in a wide range of industries. The investors shall be aware of the fact that
there is no such thing as a zero risk investment.
4. Capital growth
Portfolio management guarantees the growth of capital by reinvesting in
growth securities or by the purchase of growth securities.
5. Liquidity
Portfolio management is planned in such a way that it facilitates to take
maximum advantage of various good opportunities upcoming in the
market. The portfolio should always ensure that there are enough funds
available at short notice to take care of the investor’s liquidity requirements.
6. Marketability
Portfolio management ensures the flexibility to the investment portfolio. A
portfolio consists of such investment, which can be marketed and traded.
7. Favourable tax treatment
Portfolio management is planned in such a way to increase the effective
yield an investor gets from his surplus invested funds. By minimizing the
tax burden, yield can be effectively improved.
Page 16
Q14. Explain 5 phases of Portfolio Management

Answer:
1. Security Analysis (Analysis of the underlying securities)

 For investment purposes investor can seek various types of securities
and that too in different quantities.[Say the shares of Reliance, Idea, Tata
Motors, Tech Mahindra, ASHOK LEYLAND]
 It may be equity share, preference share, debentures and bonds
 The investor has to look upon the risk & return of the individual
securities and also the correlation between them.
 An investor should buy undervalued security (because it is selling cheap
in the market) and sell overvalued security.(because it is selling high in
the market.)
 There are two approaches to analyse whether the security is underpriced
or overpriced.
1. Fundamental analysis
2. Technical analysis.
Fundamental analysis
a. If, Current Market Price > Intrinsic/Theoretical Market Price of the

company. That means share is overvalued, Investor should sell
securities.
Current Market Price = 100 [This is the price at which share is actually
selling in the market] Theoretical Market Price = 90 [This is the price
at which share should sell in the market]. Thus, 100>90, Sell the share
b. If, Current Market Price < Intrinsic value of the company. That means
share is undervalued, Investor should buy securities.
Current Market Price= 100 [This is the price at which share is actually
selling in the market]. Theoretical Market Price = 120 [This is the price
at which share should sell in the market]. Thus, 100<120, Buy the share
Page 17
Technical analysis
According to this approach share price movements are considered to be

systematic and if past movements are studied properly they represent
certain trend & pattern [trend of 10-15% growth every year]. This will help
in forecasting the future prices and accordingly help the investor to decide
whether to buy, hold or sell the share.
 The investor will seek to build a diversified portfolio to substantially

reduce the unsystematic risk. For that investor will choose to invest in
a different industry sector having no strong correlation with each other.
Ex. Combination of securities of IT Industry, Consumer products,
Automobile industry.
 [Say after the proper analysis you decide to invest Rs.5,00,000 in the
shares of Tata Motors, Reliance, ASHOK LEYLAND]
2. Portfolio Analysis (Forming a feasible portfolio of the selected securities)
 In security analysis we have selected the securities for investment.
[Reliance, Tata Motors & ASHOK LEYLAND].
 Now combine those securities by varying the contribution (investment
amount) of each security in such a manner to form a number of
portfolios which are feasible.
 Portfolio of
(a) ASHOK LEYLAND, TATA, Reliance
(b) TATA and Reliance only,
(c) Reliance and ASHOK LEYLAND
(d) TATA and ASHOK LEYLAND

 Each such portfolio has some sort of risk [𝝈] and return [R] and this
is not just the aggregate of risk and return of individual securities.
 Risk & return of each portfolio can be calculated using a mathematical
formula.
Page 18
3. Portfolio Selection (Selecting the optimal portfolio)
 Now keeping in mind the above portfolios, select the one which suits
the need of investor.
 The optimal portfolio is one which gives the highest return at lowest
risk.
 If there is more than one portfolio having same highest return, select
the one which has the lowest risk.
 If there is more than one portfolio having same lowest risk, select the
one which has the highest return.
4. Portfolio Revision (Constantly monitoring and revising the selected

optimal portfolio)
 As the financial market is dynamic in nature and to maintain the

optimality of the portfolio, investor should always keep an eye on the
selected portfolio.
 Changes may occur which may lead to the introduction of more feasible
securities providing high return at low risk or changes may be investor
specific like additional funds to invest.
 This may require the investor to revise his portfolio by selling some
securities or adding other securities or a combination of both.
5. Portfolio Evaluation (Assessment of the performance of the portfolio)

 This process includes assessing the results of the portfolio in terms of
the risk and return over a period of time.
 It includes calculating the actual return and risk borne by the investor.
 If the actual risk and return varies with the estimated one then steps
should be taken to eliminate the deficient areas in the process of
portfolio management.
Security Porfolio Portfolio Portfolio Portfolio

Analysis Analysis Selection Revision Evaluation
Page 19
Q15. Explain how to calculate Portfolio Return

Answer:
Portfolio Return: The expected return of the portfolio of assets is simply the
weighted average of the returns of the individual securities constituting the
portfolio. The weights to be applied for the calculation of the portfolio return are
the fractions of the portfolio invested in such securities.
𝐧
𝐑 𝐩 = ∑ ̅̅̅
𝐑 𝐢 𝐖𝐢
𝐢=𝟏
𝐑 𝐩 = 𝐖𝟏 𝐑 𝟏 + 𝐖𝟐 𝐑 𝟐 + ⋯ 𝐖𝐧 𝐑 𝐧
Where,
𝐑 𝐩 = Expected return of the portfolio
𝐖𝐢 = Proportion of funds invested in security i
̅̅̅
𝐑 𝐢 = Expected return of security i
n = Number of securities in the portfolio
Let’s take a simple example. You invested `60,000 in asset 1 that produced 20%
returns and `40,000 in asset 2 that produced 12% returns. The weights of the two
assets are 60% and 40% respectively.
The portfolio returns will be:
𝐑 𝐩 = 0.60*20% + 0.40*12% = 16.8%
Q16. Explain how to calculate Risk of Portfolio having 2 securities/assets

Answer:
The variance of the portfolio with only two securities in it can be calculated with
the following formula:
σ2p = wa2 σ2a + wb2 σ2b + 2wa wb (rab σa σb )
This is similar to the old school mathematics formula of
(a + b)2 = a2 + b2 + 2ab
Where,
σ2p = portfolio variance,
wa = proportion of funds invested in first security,
Page 20
wb = proportion of funds invested in second security,

σa = Standard deviation of first security
σb = Standard deviation of second security
rab = correlation coefficient between the returns of the two securites
Risk = σ = √Variance = √wa2 σ2a + wb2 σ2b + 2wa wb (rab σa σb )
Q17. Explain how to calculate Risk of Portfolio having 3 securities/assets

Answer:
The variance of the portfolio with more than two securities in it can be calculated
with the following formula:
This is similar to the old school mathematics formula of
(a + b + c)2 = a2 + b2 + c 2 + 2ab + 2bc + 2ca
σ2p = wa2 σ2a + wb2 σ2b + wc2 σ2c + 2wa wb (rab σa σb ) + 2wb wc (rbc σb σc ) + 2wc wa (rca σc σa )
Replacing correlation x SD x SD = Covariance
σ2p = wa2 σ2a + wb2 σ2b + wc2 σ2c + 2wa wb Covab = +2wb wc Covbc = +2wc wa Covca
Alternatively Variance of 3 security portfolio can also be calculated using Matrix

Method as follows
n n
σ2p = ∑ ∑ wi wm σi σm rim
i=1 i=1
Where,
σ2p = portfolio variance,
wi = proportion of funds invested in first security,
wm = proportion of funds invested in second security,
Covim = covariance between the pair of securities a and b
n = Total number of securities in the portfolio
We know that covarince can be calculated with the following formula
Covim = σi σm rim
Hence, Risk of the portfolio having more than two securities can be modified as:
n n
σ2p = ∑ ∑ wi wm Covim
i=1 i=1
A convinient way to obtain the results is to set up the data required for calculation
in the form of a variance-covariance matrix.
Page 21
Q18. How to calculate the portfolio beta

Answer:
Similar to the formula of Portfolio Return, we can calculate the portfolio beta
using the weighted average method as follows
βp = ∑ Wi βi
Where,
βp = Portfolio Beta
βi = Beta of the each asset in the portfolio
Wi = weight of each asset in the portfolio
Q19. How to calculate proportion or weights of two securities in order to

constitute a minimum variance portfolio
Answer:
Minimum Variance Portfolio
It is the portfolio of stocks with the lowest volatilities (betas) and, therefore,
lowest sensitivities to risk. It makes maximum use of diversification to achieve
the resultant risk level that is lower than the individual risk level of each of the
stock it contains.
1. Given the required data, equation of line can be used to some extent in order
to find out the weights of securities in the portfolio under consideration.
2. On the other hand, the general formula for portfolio weight that gives
minimum variance portfolio is given by
σ2B − CovA,B
WA = 2
σA + σ2B − 2CovA,B
WB = 1 − WA
Where,
WA = Weight of security A in minimum varinace portfolio
WB = Weight of security B in minimum varinace portfolio
Page 22
Q20. Write a short note on Diversification

Answer:
"Don't put all your eggs in one basket".
Dropping the basket will break all the eggs. Placing each egg in a different basket
is more diversified. There is more risk of losing one egg, but less risk of losing all
of them.
What Is Diversification?
Taking a closer look at the concept of diversification, the idea is to create a
portfolio that includes multiple investments in order to reduce risk. Consider, for
example, an investment that consists of only stock issued by a single company. If
that company's stock suffers a serious downturn, your portfolio will sustain the
full brunt of the decline. By splitting your investment between the stocks from
two different companies, you can reduce the potential risk to your portfolio.
Diversification lowers the risk of your portfolio. Academics have complex
formulas to demonstrate how this works, but we can explain it clearly with an
example:
Let's say you have a portfolio of only airline stocks. If it is publicly announced
that airline pilots are going on an indefinite strike, and that all flights are canceled,
share prices of airline stocks will drop. Your portfolio will experience a noticeable
drop in value. If, however, you counterbalanced the airline industry stocks with a
couple of railway stocks, only part of your portfolio would be affected. In fact,
there is a good chance that the railway stock prices would climb, as passengers
turn to trains as an alternative form of transportation.
There are three main practices that can help you ensure the best diversification:
1. Spread your portfolio among multiple investment vehicles such as cash,
stocks, bonds, mutual funds and perhaps even some real estate.
2. Vary the risk in your securities. You're not restricted to choosing only blue
chip stocks. In fact, it would be wise to pick investments with varied risk
levels; this will ensure that large losses are offset by other areas.
3. Vary your securities by industry. This will minimize the impact of industry-
specific risks.
Diversification is the most important component in helping you reach your long-
range financial goals while minimizing your risk.
Page 23
At the same time, diversification is not an ironclad guarantee against loss. No

matter how much diversification you employ, investing involves taking on some
risk.
Another question that frequently baffles investors is how many stocks should be
bought in order to reach optimal diversification. According to portfolio theorists,
adding about 20 securities to your portfolio reduces almost all of the individual
security risk involved. This assumes that you buy stocks of different sizes from
various industries.
Q21. What are the theories in Portfolio Management

Answer: We are going to learn about the following theories in this chapter
1. Markowitz Model of Risk Return Optimization (Modern Portfolio Theory)
2. Capital Asset Pricing Model
3. Arbitrage Pricing Theory
4. Single Index Model
5. Capital Market Theory (Discussed with Capital Market Line Concept)
6. Random Walk Theory (Discussed in Security Analysis Chapter)
7. Efficient Market Theory (Discussed in Security Analysis Chapter)
Q22. Write a short note on Modern Portfolio Theory or Write a short note
on Markowitz model of Risk Return Optimization.
Answer:
Harry M Markowitz is credited for the introduction of new concepts of risk
measurement and their application to the selection of portfolios. He started with
the idea of risk aversion of average investors and their desire to maximise the
expected return with least risk.
- This theory is for the analysis of risk and return and their inter-
relationships.
- Harry Markowitz is regarded as the father of Modern Portfolio Theory.
- Markowitz explains an efficient portfolio as expected to yield the highest
return for a given level of risk or lowest risk for a given level of return.
Page 24
- Markowitz emphasized that quality of portfolio will be different from the

quality of individual assets within it. Thus the combined risk of two
assets taken separately is not the same risk of the two assets together.
- Investors take into account the two major aspects of the investment 1)
Risk and 2) Return.
- The Modern Portfolio Theory emphasises the trade off between risk and
return. If the investor wants a higher return, he has to take the higher risk.
But he prefers the high returns for low risk and hence the need for a trade
off arises.
- The modern portfolio theory explains the risk of each security is different
from that of others and by proper combination of securities, called
diversification risk of one is offset partly or fully by that of the other.
Q23. State the assumptions of Markowitz Model or Modern Portfolio

Theory
Answer: Assumptions of Markowitz Theory (As per ICAI)
(i) The return on an investment adequately summarises the outcome of the
investment.
(ii) The investors can visualise a probability distribution of rates of return.
(iii) The investors' risk estimates are proportional to the variance of return they
perceive for a security or portfolio.
(iv) Investors base their investment decisions on two criteria i.e. expected
return and variance of return.
(v) All investors are risk averse. For a given expected return he prefers to take
minimum risk, for a given level of risk the investor prefers to get
maximum expected return.
(vi) Investors are assumed to be rational in so far as they would prefer greater
returns to lesser ones given equal or smaller risk and are risk averse. Risk
aversion in this context means merely that, as between two investments
with equal expected returns, the investment with the smaller risk would
be preferred.
(vii) ‘Return’ could be any suitable measure of monetary inflows like NPV but
yield has been the most commonly used measure of return, so that where
the standard deviation of returns is referred to it is meant the standard
deviation of yield about its expected value.
Page 25
Note: The above text is taken from ICAI Material as it is. You can strike off point (v) as Point (vi) explains
the same thing. It has been purposely kept in the notes to explain the same in class
Alternatively- Assumptions in other words

1. Investors are rational and desire to maximise their returns with the money
available for investment.
2. The investors have free access to fair information of returns and risk.
3. The markets are efficient and absorb the information quickly and
perfectly.
4. Investors are risk averse and are in search of maximising returns and
minimising risk.
5. Standard deviation or variance and expected returns are the basis for
investors to take the decision.
6. Investor prefers higher returns for a given level of risk.
Q24. What is Efficient Frontier?

Answer:
Markowitz has formalised the risk return relationship and developed the concept
of efficient frontier. For selection of a portfolio, comparison between combinations
of portfolios is essential. As a rule, a portfolio is not efficient if there is another
portfolio with:
(a) A higher expected value of return and a lower standard deviation (risk).
(b) A higher expected value of return and the same standard deviation (risk)
(c) The same expected value but a lower standard deviation (risk)
Markowitz has defined the diversification as the process of combining assets that
are less than perfectly positively correlated in order to reduce portfolio risk without
sacrificing any portfolio returns. If an investors’ portfolio is not efficient he may:
(i) Increase the expected value of return without increasing the risk.
(ii) Decrease the risk without decreasing the expected value of return, or
(iii) Obtain some combination of increase of expected return and decrease
risk.
Page 26
This is possible by switching to a portfolio on the efficient frontier.
 If all the investments are plotted on the risk-return space, individual

securities would be dominated by portfolios, and the efficient frontier
would be containing all Efficient Portfolios
 An Efficient Portfolio has the highest return among all portfolios with
identical risk and the lowest risk among all portfolios with identical return.
 Fig – 1 depicts the boundary of possible investments in securities, A, B, C,

D, E and F; and B, C, D, are lying on the efficient frontier.
 The best combination of expected value of return and risk (standard

deviation) depends upon the investors’ utility function.
 The individual investor will want to hold that portfolio of securities which
places him on the highest indifference curve, choosing from the set of
available portfolios.
 The dark line at the top of the set is the line of efficient combinations, or
the efficient frontier. The optimal portfolio for an investor lies at the point
where the indifference curve for the concerned investor touches the
efficient frontier.
 This point reflects the risk level acceptable to the investor in order to
achieve a desired return and provide maximum return for the bearable level
of risk. The concept of efficient frontier and the location of the optimal
portfolio are explained with help of Fig-2.
Page 27
 In Fig-2 A, B, C, D, E and F define the boundary of all possible investments

out of which investments in B, C and D are the efficient portfolios lying on
the efficient frontier.
 The attractiveness of the investment proposals lying on the efficient frontier
depends on the investors’ attitude to risk. At point B, the level of risk and
return is at optimum level. The returns are highest at point D, but
simultaneously it carries higher risk than any other investment.
The shaded area represents all attainable or feasible portfolios, that is all the
combinations of risk and expected return which may be achieved with the
available securities. The efficient frontier contains all possible efficient portfolios
and any point on the frontier dominates any point to the right of it or below it.
Consider the portfolios represented by points B and E. B and E promise the same
expected return E (R1) but the risk associated with B is σ (R1) whereas the
Page 28
associated with E is σ (R2). Investors, therefore, prefer portfolios on the efficient

frontier rather than interior portfolios given the assumption of risk aversion;
obviously, point A on the frontier represents the portfolio with the least possible
risk, whilst D represents the portfolio with the highest possible rate of return with
highest risk. The investor has to select a portfolio from the set of efficient
portfolios lying on the efficient frontier. This will depend upon his risk-return
preference. As different investors have different preferences, the optimal portfolio
of securities will vary from one investor to another.
Q25. Write a short note on Capital Asset Pricing Model

Answer:
Capital Asset Pricing Model
No matter how much we diversify our investments, it's impossible to get rid of all
the risk. As investors, we deserve a rate of return that compensates us for taking
on risk. The capital asset pricing model (CAPM) helps us to calculate investment
risk and what return on investment we should expect. Here we look at the formula
behind the model, the evidence for and against the accuracy of CAPM, and what
CAPM means to the average investor.
Birth of a Model
The capital asset pricing model was the work of financial economist (and, later,
Nobel laureate in economics) William Sharpe, set out in his 1970 book "Portfolio
Theory and Capital Markets." His model starts with the idea that individual
investment contains two types of risk:
1. Systematic Risk - These are market risks that cannot be diversified away.
Interest rates, recessions and wars are examples of systematic risks.
2. Unsystematic Risk - Also known as "specific risk," this risk is specific to
individual stocks and can be diversified away as the investor increases the
number of stocks in his or her portfolio. In more technical terms, it
represents the component of a stock's return that is not correlated with
general market moves.
Modern portfolio theory shows that specific risk can be removed through
diversification. The trouble is that diversification still doesn't solve the problem
Page 29
of systematic risk; even a portfolio of all the shares in the stock market can't
eliminate that risk. Therefore, when calculating a deserved return, systematic risk
is what plagues investors most.
The Formula
Sharpe found that the return on an individual stock, or a portfolio of stocks,
should equal its cost of capital. The standard formula remains the CAPM, which
describes the relationship between risk and expected return.
Here is the formula:
Return of security under CAPM
𝐑 𝐢 = 𝐑 𝐟 + 𝛃𝒊 (𝐑 𝐦 − 𝐑 𝐟 )
Where,
R i = Return on Security
R f = Risk free rate of return
R m = Market return
β𝑖 = beta of the security
For example, let's say that the current risk free-rate is 5%, and the Sensex (market)
is expected to return to12% (Rm) next year. You are interested in determining the
return that Tata Consultancy Services will have next year. You have determined
that its beta value is 1.9. The overall stock market has a beta of 1.0, so TCS’s beta
of 1.9 tells us that it carries more risk than the overall market; this extra risk means
that we should expect a higher potential return than the 12% of the Sensex. We
can calculate this as the following:
𝐑 𝐈 = 𝟓% + 𝟏. 𝟗(𝟏𝟐% − 𝟓%) = 𝟏𝟑. 𝟑
What CAPM tells us is that TCS has a required rate of return of 13.3%. So, if you
invest in TCS, you should be getting at least 13.3% return on your investment. If
you don't think that TCS will produce those kinds of returns for you, then you
should consider investing in a different company.
CAPM's starting point is the risk-free rate - typically a 10-year government bond
yield. To this is added a premium that equity investors demand to compensate
them for the extra risk they accept. This equity market premium consists of the
expected return from the market as a whole less the risk-free rate of return. The
equity risk premium is multiplied by "beta."
What CAPM Means for You?
Page 30
 This model presents a very simple theory that delivers a simple result. The
theory says that the only reason an investor should earn more, on average, by
investing in one stock rather than another is that one stock is riskier.
 This is important for investors - especially fund managers - because they may
be unwilling to or prevented from holding cash if they feel that the market is
likely to fall. If so, they can hold low-beta stocks instead. Investors can tailor
a portfolio to their specific risk-return requirements, aiming to hold securities
with betas in excess of 1 while the market is rising, and securities with betas
of less than 1 when the market is falling.
Risk free rate of return
In CAPM there is only one risk free rate of return. It is considered that both direct
payments like dividend and capital appreciation are included in(𝑅𝑓 ).
When two risk free rates are given.
It is better to go moderate and consider the average of the two rates. Aggressive
people will consider the higher rate and conservative people will consider the
lower rate.
Two important aspects of CAPM
a. Stock market has nothing to do with the diversified risk or the investor
having a diversified portfolio.
b. Investor gets the return only for the systematic risk, as unsystematic risk can
be eliminated through diversification.
Conclusion
The capital asset pricing model is by no means a perfect theory. But the spirit of
CAPM is correct. It provides a usable measure of risk that helps investors
determine what return they deserve for putting their money at risk.
Page 31
Q26. What are the assumptions of CAPM

Answer:
All investors:
1. Aim to maximise economic utilities.
2. Are rational and risk averse.
3. Are broadly diversified across a range of investments.
4. Are price takers i.e. they cannot influence price.
5. Can lend and borrow unlimited amount @ risk free rate of interest (R f ).
6. Trade without any transaction or taxation cost
7. Assumes all information is available at the same time to all investors.
8. Assumes that all assets are divisible and liquid asset.
9. Assumes that Securities or capital asset does not face any bankruptcy or
insolvency.
Q27. What are the Advantages and Limitatins of CAPM

Answer:
Advantages of CAPM
1. Only systematic risk: It considers only systematic risk reflecting a reality
in which most investors have diversified portfolios from which unsystematic
risk has been essentially eliminated.
2. Better method to calculate cost of equity: It is generally seen as much
better method of calculating the cost of equity than the dividend growth
model (DGM) in that it explicitly takes into account a company’s level of
systematic risk relative to the stock market as a whole. It is useful in
computing cost of equity of a company which does not declare dividend.
3. Can be used as risk adjusted discounted rate (RADR): It provides
reasonable basis for estimating the required return on an investment which
has risk in-built into it and hence can be used as RADR in capital budgeting.
Page 32
Limitations of CAPM
1. Unreliable Beta: Shares of many companies may not have reliable beta.
2. Hard to get the market information: Information on risk free rate of return,
return on market portfolio may not be possible to obtain as there exist
multiple rates in the market.
3. No transaction cost
Q28. How to find out if the stock is undervalued, overvalued or correctly

valued.
Answer:
In context of returns
Situation Action Remarks
CAPM < Expected return Buy Stock is undervalued and hence it gives
more return than what it should give.
CAPM > Expected return Sell Stock is overvalued and hence it gives
less return than what it should give.
CAPM = Expected return Hold Stock is correctly valued and hence it
gives same return what it should give.
In context of price
Situation Action Remarks
Actual Market Price < CAPM Buy Stock is undervalued and hence it
gives more return than what it should
give.
Actual Market Price > CAPM Sell Stock is overvalued and hence it
gives less return than what it should
give.
Actual Market Price = CAPM Hold Stock is correctly valued and hence it
gives same return what it should give.
In context of SML [Security Market Line, discussed later in the topic 3 Market
Lines]
Page 33
Situation Action Value Why

Assets above Buy Undervalued Because the assets “too” high
SML expected returns means their
price is “too” low as compared to
the “fair” CAPM value
Assets below Sell Overvalued Because the assets “too” low
SML expected returns means their
price is “too” high as compared to
the “fair” CAPM value
Assets on Hold Correctly -
SML valued
Q29. Write a short note on Arbitrage Pricing Theory

Answer:
Arbitrage Pricing Theory
We have discussed CAPM, and observed that it is a model with only one
systematic factor (1 Beta). On the other hand APT model specifies the pricing
relationship with number of “systematic” factors.
 Arbitrage Pricing Model is created by Stephen Ross in 1976
 It can be well said that APT is the plural form of CAPM with some
modifications.
 The APT is an approach to determine the asset price based on law of one
price i.e. one security will have the same price in two markets.
 It is a multifactor model of asset pricing.
 Very few assumptions to consider under APT model
1. All securities have finite expected values and variances.
2. Some agents can form well diversified portfolios.
3. There are no taxes.
4. And no transaction cost.
Page 34
The Arbitrage Pricing Theory Model

The APT model was first described by Steven Ross in an article entitled The
Arbitrage Theory of Capital Asset Pricing, which appeared in the Journal of
Economic Theory in December 1976. The Arbitrage Pricing Theory assumes
that each stock's (or asset's) return to the investor is influenced by several
independent factors.
The APT Formula
Stocks/Portfolios Returns according to APT will be
𝐑 𝐣 = 𝐑 𝐟 + 𝛃𝟏 𝛌𝟏 + 𝛃𝟐 𝛌𝟐 + 𝛃𝟑 𝛌𝟑 + ⋯ + 𝐞𝐢
Where,
λ1 , λ2 , λ3 are average risk premium for each of the factors in the model
β1 , β2 , β3 are betas of the security for each of the factors in the model
ei is random error unique to security with mean zero.
The APT model also states the risk premium of a stock depends on two factors:
1. The risk premiums associated with each of the factors described above
2. The stock's own sensitivity to each of the factors; like the beta concept
Factors Used in the Arbitrage Pricing Theory
It's one thing to describe the APT theory in terms of simple formulas, but it's
another matter entirely to identify the factors used in this theory. That's because
the theory itself does not tell the investor what those factors are for a particular
stock or asset, and for a very good reason. In practice, and in theory, one stock
might be more sensitive to one factor than another.
For example, the price of a share of ExxonMobil might be very sensitive to the
price of crude oil, while a share of Colgate Palmolive might be relatively
insensitive to the price of oil.
In fact, the Arbitrage Pricing Theory leaves it up to the investor, or analyst, to
identify each of the factors for a particular stock. Therefore, the real challenge
for the investor is to identify three items:
1. Each of the factors affecting a particular stock
2. The expected returns for each of these factors
3. The sensitivity of the stock to each of these factors
Page 35
Identifying and quantifying each of these factors is no trivial matter, and is one
of the reasons the Capital Asset Pricing Model remains the dominant theory to
describe the relationship between a stock's risk and return.
Keeping in mind the number and sensitivities of a stock to each of these factors
is likely to change over time, Ross and others identified the following macro-
economic factors they felt played a significant role in explaining the return on
a stock:
1. Inflation
2. GNP or Gross National Product
3. Investor Confidence
4. Shifts in the Yield Curve
With that as guidance, the rest of the work is left to the stock analyst.
Additional Reading (Not covered in Syllabus)

APT versus the Capital Asset Pricing Model
As mentioned, the Arbitrage Pricing Theory and the Capital Asset Pricing
Model (CAPM) are the two most influential theories on stock and asset pricing
today. The APT model is different from the CAPM in that it is far less
restrictive in its assumptions. APT allows the individual investor more freedom
to develop a model that explains the expected return for a particular asset.
Intuitively, the APT makes a lot of sense because it removes the CAPM
restrictions, and basically states "The expected return on an asset is a function
of many factors as well as the sensitivity of the stock to these factors." As these
factors move, so does the expected return on the stock, and therefore its value
to the investor.
In the CAPM theory, the expected return on a stock can be described by the
movement of that stock relative to the rest of the market. The CAPM is just a
simplified version of the APT, whereby the only factor considered is the risk of
a particular stock relative to the rest of the market, as described by the stock's
beta.
From a practical standpoint, CAPM remains the dominant pricing model used
today. When compared to the Arbitrage Pricing Theory, the Capital Asset
Pricing Model is both elegant and relatively simple to calculate.
Page 36
Q30. Write a short note on Single Index Model

Answer:
Single Index Model
The single-index model (SIM) is a simple asset pricing model to measure both
the risk and the return of a stock, commonly used in the finance industry.
The single index model equation is:
𝐑 𝐢 = 𝛂𝐢 + 𝛃𝐢 𝐑 𝐦 +∈𝐢
Where,
R i = expected return on security i
αi = alphacoefficient or intercept of the straight line
βi = beta coefficient or slope of the line
R m = the rate of return on market index
∈i = unsystematic risk of the security
This equation shows that the stock return is influenced by the market (beta),
has a firm specific expected value (alpha) and firm-specific unexpected
component (residual). Each stock's performance is in relation to the
performance of a market index. Security analysts often use the SIM for such
functions as computing stock betas, evaluating stock selection skills, and
conducting event studies.
To simplify analysis, the single-index model assumes that there is only 1
macroeconomic factor that causes the systematic risk affecting all stock returns
and this factor can be represented by the rate of return on a market index, such
as the S&P 500.
According to this model, the return of any stock can be decomposed into the
expected excess return of the individual stock due to firm-specific factors,
commonly denoted by its alpha coefficient (α), the return due to
macroeconomic events that affect the market, and the unexpected
microeconomic events that affect only the firm.
The term 𝛃𝐢 𝐑 𝐦 represents the movement of the market modified by the stock's
beta, while ∈𝐢 represents the unsystematic risk of the security due to firm-
specific factors. Macroeconomic events, such as changes in interest rates or the
Page 37
cost of labor, causes the systematic risk that affects the returns of all stocks,
and the firm-specific events are the unexpected microeconomic events that
affect the returns of specific firms, such as the death of key people or the
lowering of the firm's credit rating, that would affect the firm, but would have
a negligible effect on the economy. In a portfolio, the unsystematic risk due to
firm-specific factors can be reduced to zero by diversification.
The index model is based on the following:
 Most stocks have a positive covariance because they all respond similarly
to macroeconomic factors.
 However, some firms are more sensitive to these factors than others, and
this firm-specific variance is typically denoted by its beta (β), which
measures its variance compared to the market for one or more economic
factors.
 Covariance’s among securities result from differing responses to
macroeconomic factors. Hence, the covariance of each stock can be found
by multiplying their betas and the market variance:
The covariance of returns between securities i and j
𝐂𝐨𝐯𝐢𝐣 = 𝛃𝐢 𝛃𝐣 𝛔𝟐𝐦
This equation greatly reduces the computations required to determine
covariance because otherwise the covariance of the securities within a portfolio
must be calculated using historical returns, and the covariance of each possible
pair of securities in the portfolio must be calculated independently. With this
equation, only the betas of the individual securities and the market variance
need to be estimated to calculate covariance. Hence, the index model greatly
reduces the number of calculations that would otherwise have to be made to
model a large portfolio of thousands of securities.
The Total Risk = Systematic risk + Unsystematic risk
𝛔𝟐 = β2i σ2m +∈2i
Where,
σ2 = total variance
βi 2 σ2m = systematic variance
σ2∈i = unsystematc variance
Page 38
A portfolio variance
𝟐
𝛔𝐩 = [(∑ 𝐖𝐢 𝛃𝐢 ) 𝛔𝟐𝐦 ] + [∑(𝐖𝐢 𝛜𝐢 )𝟐 ]
𝟐
Portfolios Alpha and Beta

A portfolios alpha value is the weighted average of its alpha values of its
component securities and the weight being the proportion of investment in a
security.
𝐍
𝛂𝐩 = ∑ 𝐰𝐢 𝛂𝐢
𝐢=𝟏
A portfolios beta value is the weighted average of its beta values of its
component securities and the weight being the proportion of investment in a
security.
𝐍
𝛃𝐩 = ∑ 𝐰𝐢 𝛃𝐢
𝐢=𝟏
Q31. Write a short note on Portfolio Evaluation Measures

or How to measure the performance of a portfolio or security?
or Write a short note on Sharpe Ratio, Treynor Ratio, Jensen’s Alpha
Answer:
Portfolio Evaluation Measures
1. Sharpe Ratio
 Is the measurement of average return over and above the risk free rate of
return (risk premium) per unit of portfolio risk.
 Uses standard deviation as the measure of risk.
𝐑𝐢 − 𝐑𝐟
𝐒𝐡𝐚𝐫𝐩𝐞 𝐫𝐚𝐭𝐢𝐨 =
𝛔𝐢
R i = Expected return on stock i
σi = Standard deviation for the rates of returns for stock i
Page 39
2. Treynor Ratio
 Is the measurement of average return over and above the risk free rate of
return (risk premium) per unit of risk of market portfolio.
 Uses beta as the measure of risk.
𝐑𝐢 − 𝐑𝐟
𝐓𝐫𝐞𝐲𝐧𝐨𝐫 𝐫𝐚𝐭𝐢𝐨 =
𝛃𝐢
βi = beta of stock i
3. Jensen’s Alpha
 Used to determine the abnormal return of a security or portfolio of
securities over the theoretical expected return.
 After all, riskier assets will have higher expected returns than less risky
assets. If an asset's return is even higher than the risk adjusted return, that
asset is said to have "positive alpha" or "abnormal returns". Investors are
constantly seeking investments that have higher alpha.
𝐉𝐞𝐧𝐬𝐞𝐧’𝐬 𝐀𝐥𝐩𝐡𝐚 = 𝐄𝐱𝐩𝐞𝐜𝐭𝐞𝐝/𝐀𝐜𝐭𝐮𝐚𝐥 𝐑𝐞𝐭𝐮𝐫𝐧 − 𝐑𝐞𝐪𝐮𝐢𝐫𝐞𝐝 𝐫𝐞𝐭𝐮𝐫𝐧[𝐂𝐀𝐏𝐌 𝐫𝐞𝐭𝐮𝐫𝐧]
𝐉𝐞𝐧𝐬𝐞𝐧’𝐬 𝐀𝐥𝐩𝐡𝐚 = 𝐑𝐢 − (𝐑𝐟 + 𝛃(𝐑𝐦 − 𝐑𝐟)
Q32. Write a short note on Sharpe’s Optimal Portfolio Theory

Answer:
The optimal portfolio concept falls under the modern portfolio theory. The theory
assumes (among other things) that investors fanatically try to minimize risk while
striving for the highest return possible. The theory states that investors will act
rationally, always making decisions aimed at maximizing their return for their
acceptable level of risk.
The optimal portfolio was used in 1952 by Harry Markowitz, and it shows us that
it is possible for different portfolios to have varying levels of risk and return. Each
investor must decide how much risk they can handle and then allocate (or
diversify) their portfolio according to this decision.
Page 40
Steps for finding out the stocks to be included in the optimal portfolio
1. Find out the “excess return to beta” ratio for each stock under consideration
using Treynor ratio.
2. Rank them from the highest to the lowest.
3. Proceed to calculate 𝐶𝑖 for all the stocks/portfolios according to the ranked
order using the following formula:
(R i − R f )βi
σ2m ∑N
i=1
σ2ei
Ci =
2 N β2i
1 + σm ∑i=1 2
σei
Where,
σ2m = Variance of the market index
σ2ei
= Variance of the stock ′ s movement that is not associated with the
movement of market index i. e stock ′ s unsystematic risk.
(a) Compute the cut-off point which gives the highest value of 𝐶𝑖 . and is taken
is C* The stock whose excess return to risk ratio is above the cut-off ratio
are selected and all whose ratios are below are rejected. The main reason
for this selection is that since securities are ranked from highest excess
return to beta to lowest, and if particular security belongs to optimal
portfolio all higher ranked securities also belong to optimal portfolio.
(b) Once we came to know which securities are to be included in the optimum
portfolio, we shall calculate the percent to be invested in each security by
using the following formula:
Zi
Xi =
∑N
j=1 Zi
Where,
βi R i − R o
Zi = 2 ( − C∗ )
σei βi
Page 41
The first portion (Xi ) determines the weight of each stock and total comes
to 1 to ensure that all funds are invested and second portion (𝑍𝑖 ) determines
the relative investment in each security.
Q33. Write a short note on Portfolio Rebalancing Theories
or Write a short note on Buy and Hold Policy
or Write a short note on Constant Mix Policy or Constant Ratio Plan
or Write a short note on Constant Proportion Portfolio Insurance
Policy (CPPI)
Answer:
Portfolio Rebalancing Theories
The investments in a portfolio will perform according to the market. As time goes
on, a portfolio's current asset allocation will drift away from an investor's original
target asset allocation (i.e., their preferred level of risk exposure).
If left unadjusted, the portfolio will either become too risky, or too conservative.
If it becomes too risky, that will tend to increase long-term returns, which is
desirable. But when the excessive risks show up in the short term, the investor
might have a tendency to do the worst possible thing at the worst possible time
(i.e., sell at the bottom), thus dramatically diminishing their ending wealth.
If the portfolio is allowed to drift to a too conservative status, then excessive short-
term risk is less likely, which is desirable. However, long-term returns would also
tend to be lower than desired, which is less desirable. So it is best to maintain a
portfolio's risk profile reasonably close to an investor's level of risk tolerance.
There are three strategies for portfolio rebalancing
1) Buy-and-Hold,
2) Constant Mix Policy
3) Constant-Proportion Portfolio Insurance Policy (CPPI)
1) Buy and Hold Policy (Do nothing policy)
Buy and hold is a long-term investment strategy based on the view that in the
long run financial markets give a good rate of return despite periods of
volatility or decline. This viewpoint also holds that short-term market timing,
i.e. the concept that one can enter the market on the lows and sell on the highs,
does not work; attempting timing gives negative results, at least for small or
unsophisticated investors, so it is better for them to simply buy and hold.
Page 42
The antithesis of buy-and-hold is the concept of day trading, in which money

can be made in the short term if an individual tries to short on the peaks, and
buy on the lows with greater money coming with greater volatility.
One of the strongest arguments for the buy and hold strategy is the efficient-
market hypothesis (EMH): If every security is fairly valued at all times, then
there is really no point to trade. Some take the buy-and-hold strategy to an
extreme, advocating that you should never sell a security unless you need the
money.
 Under this strategy investors set a limit (floor) below which he does not
wish the value of portfolio should go.
 Therefore, he invests an amount equal to floor value in non-fluctuating
assets (Bonds). Since the value of portfolio is linearly related to value of
stocks the pay-off diagram is a straight line.
 This can be better understood with the help of an example. Suppose a
portfolio consisting of Debt/ Bonds for `50,000 of and `50,000 in equity
shares currently priced at `100 per share. If price of the share moves from
`100 to `200 the value of portfolio shall become `1,50,000.
 This policy is suitable for the investor whose risk tolerance is positively
related to portfolio and stock market return but drops to zero of below
floor value.
 Concluding, it can be said that following are main features of this policy:
1. The value of portfolio is positively related and linearly dependent
on the value of the stock.
2. The value of portfolio cannot fall below the floor value i.e.
investment in Bonds.
3. This policy performs better if initial percentage is higher in stock
and stock outperform the bond. Reverse will happen if stock under
perform in comparison of bond or their prices goes down.
2) Constant Mix Policy

Contrary to above policy this policy is a ‘do something policy’. Under this
policy investor maintains an exposure to stock at a constant percentage of total
portfolio.
This strategy involves periodic rebalancing to required (desired) proportion
by purchasing and selling stocks as and when their prices goes down and up
respectively.
Page 43
In other words this plan specifies that value of aggressive portfolio to the value
of conservative portfolio will be held constant at a pre-determined ratio.
However, it is important to note that this action is taken only if there is change
in the prices of share at a predetermined percentage.
For example if an investor decided his portfolio shall consist of 60% in equity
shares and balance 40% in bonds on upward or downward of 10% in share
prices he will strike a balance.
 In such situation if the price of share goes down by 10% or more, he
will sell the bonds and invest money in equities so that the proportion
among the portfolio i.e. 60:40 remains the same.
 Accordingly if the prices of share goes up by 10% or more he will sell
equity shares and invest in bonds so that the ratio remains the same i.e.
60:40.
This strategy is suitable for the investor whose tolerance varies proportionally
with the level of wealth and such investor holds equity at all levels
Continuing above example let us how investor shall rebalance his portfolio
under different scenarios as follows:
Share Change Value of Value of Total Action Total
Price Shares Bonds Shares
100 Starting Level 60000 40000 100000 600
80 20% Before 48000 40000 88000
Rebalancing
After 52800 35200 88000 Buy 60 Shares at 660
Rebalancing 80=`4800 and
sell bonds worth
`4800
85 6.25% Before 56100 35200 91300 No action will
Rebalancing be taken as the
After 56100 35200 91300 change is not 660
Rebalancing 10% or more
55 35% Before 36300 35200 71500
Rebalancing
After 42900 28600 71500 Buy 120 Shares 780
Rebalancing at 55= `6600
and sell bonds
worth `6600
88 60% Before 68640 28600 97240
Rebalancing
After 58344 38896 97240 Sell 117 Shares 663
Rebalancing at 88=`10296
and Buy bonds
worth `10296
Page 44
3) Constant Proportion Portfolio Insurance Policy

Constant proportion portfolio insurance (CPPI) is a trading strategy which
allows an investor to maintain an exposure to the upside potential of a risky
asset while provide a capital guarantee against downside risk.
In order to guarantee the capital invested, the seller of portfolio insurance
maintains a position in a Treasury bonds or liquid monetary instruments,
together with a leveraged position in a "risky asset", usually a market index.
The CPPI provides leverage through a multiplier. This multiplier is set to 100
divided by the crash size (as a percentage) that is being insured against.
For example,
Say an investor has a $100 portfolio, a floor of $90 (price of the bond to
guarantee his $100 at maturity) and a multiplier of 5 (ensuring protection
against a drop of at most 20% before rebalancing the portfolio).
Then on day 1, the writer will allocate (5 * ($100 – $90)) = $50 to the risky
asset and the remaining $50 to the riskless asset (the bond).
The exposure will be revised as the portfolio value changes, i.e. when the risky
asset performs and with leverage multiplies by 5 the performance (or vice
versa). Same is with the bond. These rules are predefined and agreed once and
for all during the life of the product.
Equity Value = Multiplier x [Portfolio Value - Floor Value]
The pay-off under this strategy can be understood better with the help of an
example. Suppose wealth of Mr. A is `10,00,000, a floor value of `7,50,000
and a multiplier of 2. Since the initial cushion (difference between Portfolio
Value and Floor) is `2,50,000, the initial investment in the share shall be
`5,00,000 (double of the initial cushion). Accordingly, initial portfolio mix
shall be consisted of `5,00,000 in shares and balance `5,00,000 in Bonds.
Situation 1: Suppose stock market rises from 100 to 150. The value of shares
of Mr. A’s holding shall rise from `5,00,000 to `7,50,000 and value of
portfolio shall jump to `12,50,000 and value of cushion to `7,50,000. Since
the CPPI Policy requires the component of shares should go up to `10,00,000.
This will necessitate the selling of bonds amounting `2,50,000 and reinvesting
proceeds in shares.
Page 45
Situation 2: If stock market falls from 100 to 80, the value of shares of
portfolio falls from `5,00,000 to `4,00,000 resulting in reduction of value of
portfolio to `9,00,000 and cushion to `1,50,000. Since as per CPPI the share
component should be `3,00,000 (`1,50,000 x 2), hence shares of `1,00,000
should be sold and invest in Bonds. Thus from above it is clear that as per
CPPI sell the shares as their prices fall and buy them as their prices rise
Q34. Make a comparative evaluation of Portfolio Rebalancing Theories

Answer:
Basis Buy & Hold Constant Mix CPPI
Policy Policy
Pay off line Straight Concave Convex
Protection in Definite in Not much in Good in Down
Down/Up Down market down market but market and
Markets relatively poor in performs well in
up market Up market
Performance in Performs Tend to do well Performs poorly
flat but between in flat market
fluctuating Constant and
market CPPI
Page 46
Q35. Write a short note on Short Selling

Answer:
What is Short Selling?
In purchasing stocks, you buy a piece of ownership in the company. The buying
and selling of stocks can occur with a stock broker or directly from the company.
Brokers are most commonly used. They serve as an intermediary between the
investor and the seller and often charge a fee for their services.
In finance short selling (also known as shorting or going short) is the practice of
selling securities or other financial instruments that are not currently owned, and
subsequently repurchasing them ("covering").
The short seller borrows shares and immediately sells them. The short seller then
expects the price to decrease, when the seller can profit by purchasing the shares
to return to the lender.
When using a broker, you will need to set up an account. The account that's set
up is either a cash account or a margin account. A cash account requires that you
pay for your stock when you make the purchase, but with a margin account the
broker lends you a portion of the funds at the time of purchase and the security
acts as collateral.
Page 47
When an investor goes long on an investment, it means that he or she has bought
a stock believing its price will rise in the future. Conversely, when an investor
goes short, he or she is anticipating a decrease in share price.
Short selling is the selling of a stock that the seller doesn't own. More specifically,
a short sale is the sale of a security that isn't owned by the seller, but that is
promised to be delivered. That may sound confusing, but it's actually a simple
concept.
Still with us? Here's the skinny: when you short sell a stock, your broker will lend
it to you. The stock will come from the brokerage's own inventory, from another
one of the firm's customers, or from another brokerage firm. The shares are sold
and the proceeds are credited to your account. Sooner or later, you must "close"
the short by buying back the same number of shares (called covering) and
returning them to your broker. If the price drops, you can buy back the stock at
the lower price and make a profit on the difference. If the price of the stock rises,
you have to buy it back at the higher price, and you lose money.
Because you don't own the stock you're short selling (you borrowed and then sold
it), you must pay the lender of the stock any dividends or rights declared during
the course of the loan. If the stock splits during the course of your short, you'll
owe twice the number of shares at half the price.
Page 48
Q36. Write a short note on Market Lines

Answer:
The Market lines in our chapter is based on the concept of Equation of Line
Equation of Line (Not a part of the syllabus or this question)
Equation of line tells us that for any value of X what will be the value of Y.
The formula for equation of line is
Y = mX +b
Where,
m= slope, b=the intercept also m and b designate constants
Say, the equation of line is Y=2x + 1
With that equation you can now choose any value for x and find the matching
value for y
For example, when x is 1:
y = 2×1 + 1 = 3
Or we could choose another value for x, such as 7:
y = 2×7 + 1 = 15
And so when x=7 you will have y=15
Three market Lines
1) Capital Market Line

The capital market line (CML) represents portfolios that optimally combine
risk and return.
CML differs from the more popular efficient frontier in that it includes risk-
free investments. The intercept point of CML and efficient frontier would
result in the most efficient portfolio, called the tangency portfolio.
Exhibit 1: The capital market line is the tangent line to the efficient
frontier that passes through the risk-free rate on the expected return axis.
All points along the CML have superior risk-return profiles to any portfolio
on the efficient frontier, with the exception of the Market Portfolio, the point
on the efficient frontier to which the CML is the tangent.
Page 49
CML can be represented by following equation

𝛔𝐢
𝐑𝐢 = 𝐑𝐟 + (𝐑 𝐦 − 𝐑 𝐟 )
𝛔𝐦
2) Security market line

A graphical representation of CAPM is the Security Market Line, (SML). This
line indicates the rate of return required to compensate at a given level of risk.
Plotting required return on Y axis and Beta on the X-axis we get an upward
sloping line which is given by (Rm – Rf), the risk premium.
The higher the Beta value of a security, higher would be the risk premium
relative to the market. This upward sloping line is called the Security Market
Line. It measures the relationship between systematic risk and return. SML
Equation can be given as:
𝐑 𝐢 = 𝐑 𝐟 + 𝛃𝒊 (𝐑 𝐦 − 𝐑 𝐟 )
Where,
R i = Return on Security
R m = Market return
β𝑖 = beta of the security
Page 50
3) Security Characteristic Line
Characteristic line is a straight line on a graph that shows the relationship over
time between returns on a stock and returns on the market. The SCL is plotted
on a graph where the Y-axis is the return on a security and the X-axis is the
return of the market in general.
𝐑 𝐢 = 𝛂𝐢 + 𝛃𝐢 𝐑 𝐦
Where,
R i = expected return on security i
αi = alpha
βi (R m ) = component of return due to market movement
Q37. Write a short note on Alpha of the security

Answer:
Alpha
Alpha is a risk-adjusted measure of the so-called active return on an investment.
It is the return in excess of the compensation for the risk borne, and thus
commonly used to assess active managers' performances. Often, the return of a
benchmark is subtracted in order to consider relative performance, which yields
Jensen's alpha.
𝛂𝐢 <0: the investment has earned too little for its risk (or, was too risky for
the return)
𝛂𝐢 = 0: the investment has earned a return adequate for the risk taken
𝛂𝐢 >0: the investment has a return in excess of the reward for the assumed
risk
For instance, although a return of 20% may appear good, the investment can still
have a negative alpha if it's involved in an excessively risky position
Investors can use both alpha and beta to judge a manager's performance. If the
manager has had a high alpha, but also a high beta, investors might not find that
acceptable, because of the chance they might have to withdraw their money when
the investment is doing poorly.
Page 51
Alpha can be calculated as follows

α= Actual/Expected Return – CAPM Return
Additional Reading
1. Alpha is one of five technical risk ratios; the others are beta, standard deviation, R-
squared, and the Sharpe ratio. These are all statistical measurements used in modern
portfolio theory (MPT).
2. All of these indicators are intended to help investors determine the risk-reward profile
of a portfolio. Simply stated, alpha is often considered to represent the value that a
portfolio manager adds to or subtracts from a fund's return.
3. A positive alpha of 1.0 means the fund has outperformed its benchmark index by 1%.
Correspondingly, a similar negative alpha would indicate an underperformance of 1%.
4. If a CAPM analysis estimates that a portfolio should earn 10% based on the risk of the
portfolio but the portfolio actually earns 15%, the portfolio's alpha would be 5%. This
5% is the excess return over what was predicted in the CAPM model.
Page 52
Q38. Write a short note on Active and Passive Portfolio Strategy

Answer:
Active and Passive Portfolio Strategy
Portfolio Management Strategies refer to the approaches that are applied for the
efficient portfolio management in order to generate the highest possible returns at
lowest possible risks. There are two basic approaches for portfolio management
including Active Portfolio Management Strategy and Passive Portfolio
Management Strategy.
A. Active Portfolio Management Strategy
The Active portfolio management relies on the fact that particular style of
analysis or management can generate returns that can beat the market. It
involves higher than average costs and it stresses on taking advantage of
market inefficiencies. It is implemented by the advices of analysts and
managers who analyze and evaluate market for the presence of
inefficiencies.
The active management approach of the portfolio management involves the
following styles of the stock selection.
Top-down Approach: In this approach, managers observe the market as a
whole and decide about the industries and sectors that are expected to
perform well in the ongoing economic cycle. After the decision is made on
the sectors, the specific stocks are selected on the basis of companies that
are expected to perform well in that particular sector.
Bottom-up: In this approach, the market conditions and expected trends
are ignored and the evaluations of the companies are based on the strength
of their product pipeline, financial statements, or any other criteria. It
stresses the fact that strong companies perform well irrespective of the
prevailing market or economic conditions.
B. Passive Portfolio Management Strategy
Passive asset management relies on the fact that markets are efficient and
it is not possible to beat the market returns regularly over time and best
returns are obtained from the low cost investments kept for the long term.
The passive management approach of the portfolio management involves
the following styles of the stock selection.
Page 53
Efficient market theory: This theory relies on the fact that the information
that affects the markets is immediately available and processed by all
investors. Thus, such information is always considered in evaluation of the
market prices. The portfolio managers who follows this theory, firmly
believes that market averages cannot be beaten consistently.
Indexing: According to this theory, the index funds are used for taking the
advantages of efficient market theory and for creating a portfolio that
impersonate a specific index. The index funds can offer benefits over the
actively managed funds because they have lower than average expense
ratios and transaction costs.
Apart from Active and Passive Portfolio Management Strategies, there are
three more kinds of portfolios including Patient Portfolio, Aggressive
Portfolio and Conservative Portfolio.
Patient Portfolio: This type of portfolio involves making investments in well-

known stocks. The investors buy and hold stocks for longer periods. In this
portfolio, the majority of the stocks represent companies that have classic growth
and those expected to generate higher earnings on a regular basis irrespective of
financial conditions.
Aggressive Portfolio: This type of portfolio involves making investments in
“expensive stocks” that provide good returns and big rewards along with carrying
big risks. This portfolio is a collection of stocks of companies of different sizes
that are rapidly growing and expected to generate rapid annual earnings growth
over the next few years.
Conservative Portfolio: This type of portfolio involves the collection of stocks
after carefully observing the market returns, earnings growth and consistent
dividend history.
Page 54
Q39. Discuss Principles and Management of Hedge Funds

Answer:
Principle and Management of Hedge Funds
Hedge funds are aggressively managed portfolio of investments that uses

advanced investment strategies such as leverage, long, short and derivative
positions in both domestic and international markets with the goal of generating
high returns (either in an absolute sense or over a specified market benchmark).
A hedge fund is an investment vehicle that is structured as a corporation or
partnership. The fund is managed by an investment manager in the form of an
organization or company that is legally and financially distinct from the hedge
fund and its portfolio of assets. Many investment managers utilize service
providers for operational support. Service providers include prime brokers, banks,
administrators, distributors and accounting firms.
A hedge fund is a collective investment scheme, often structured as a limited
partnership that invests private capital speculatively to maximize capital
appreciation. Hedge funds tend to invest in a diverse range of markets, investment
instruments, and strategies
Hedge funds are often open-ended and allow additions or withdrawals by their
investors. A hedge fund's value is calculated as a share of the fund's net asset
value, meaning that increases and decreases in the value of the fund's investment
assets (and fund expenses) are directly reflected in the amount an investor can
later withdraw.
Most hedge fund investment strategies aim to achieve a positive return on
investment regardless of whether markets are rising or falling ("absolute return").
Types of funds
1. Open-ended hedge funds continue to issue shares to new investors and
allow periodic withdrawals at the net asset value ("NAV") for each share.
2. Closed-ended hedge funds issue a limited number of tradable shares at
inception.
Page 55
Features of Hedge Funds

1. Hedge funds utilize a variety of financial instruments to reduce risk,
enhance returns and minimize the correlation with equity and bond
markets. Many hedge funds are flexible in their investment options (can use
short selling, leverage, derivatives such as puts, calls, options, futures etc).
2. Hedge funds vary enormously in terms of investment returns, volatility and
risk. Many, but not all, hedge fund strategies tend to hedge against
downturns in the markets being traded.
3. Many hedge funds have the ability to deliver non market correlated returns.
4. Many hedge funds have as an objective consistency of returns and capital
preservation rather than magnitude of returns.
5. Many hedge funds are managed by experienced investment professionals
who are generally disciplined and diligent.
Hedging Strategies
1. Selling Short: Selling shares without owning them, hoping to buy them
back at a future date at a lower price in the expectation that their price will
drop.
2. Using Arbitrage: Seeking to exploit pricing inefficiencies between related
securities- for example, can be long convertible bonds and short the
underlying issuer’s equity.
3. Trading options and derivatives: Contracts whose values are based on the
performance of any underlying financial asset, index or other investment.
4. Investing in anticipation of a specific Event: Merger transaction, hostile
takeover, spin-off, exiting of bankruptcy proceedings etc.
5. Investing in Deeply Discounted securities: of companies about to enter or
exit financial distress or bankruptcy, often below liquidation value.
Benefits of Hedge Funds
1. Many hedge funds strategies have the ability to generate positive returns
in both rising and falling equity and bond markets.
2. Inclusion of hedge funds in a balanced portfolio reduces overall portfolio
risk and volatility and increases returns.
3. Huge variety of hedge fund investment styles- many uncorrelated with
each other-provides investors with a wide choice of hedge fund strategies
to meet their investment objectives. Academic research proves hedge
funds have higher returns and lower overall risk than traditional
investment funds.
Page 56
4. Hedge funds provide an ideal long term investment solution, eliminating

the need to correctly time entry and exit from markets.
5. Adding hedge funds to an investment portfolio provides diversification
not otherwise available in traditional investing.
Reasons for investing in Hedge Funds
1. Potential for higher returns, especially in a bear market
2. It provides diversification benefits
Q40. Explain different types of Asset Allocation Strategies.

Answer:
Many portfolios containing equities also contain other asset categories, so the
management factors are not limited to equities. There are four asset allocation
strategies:
1. Strategic Asset Allocation:
✓ Strategic asset allocation is an investment strategy focused on the
needs of the investor rather than the constant tracking of the markets,
and is thought to remove the influence of emotion from investment
strategies.
✓ Under this strategy, optimal portfolio mixes based on returns, risk, and
co-variances is generated using historical information and adjusted
periodically to restore target allocation within the context of the
constraints.
Page 57
2. Tactical Asset Allocation:

✓ Tactical asset allocation is an active management portfolio
strategy that shifts the percentage of assets held in various
categories to take advantage of market pricing anomalies or
strong market sectors.
✓ This strategy allows portfolio managers to create extra value
by taking advantage of certain situations in the marketplace. It
is as a moderately active strategy since managers return to the
portfolio's original strategic asset mix when desired short-term
profits are achieved.
3. Insured Asset Allocation:

✓ With an insured asset allocation strategy, you establish a base
portfolio value under which the portfolio should not be allowed to
drop.
✓ As long as the portfolio achieves a return above its base, you
exercise active management to try to increase the portfolio value
as much as possible.
✓ If, however, the portfolio should ever drop to the base value, you
invest in risk-free assets so that the base value becomes fixed. At
such time, you would consult with your advisor on re-allocating
assets, perhaps even changing your investment strategy entirely.
✓ Insured asset allocation may be suitable for risk-averse investors
who desire a certain level of active portfolio management but
appreciate the security of establishing a guaranteed floor below
which the portfolio is not allowed to decline.
Page 58
✓ For example, an investor who wishes to establish a minimum

standard of living during retirement might find an insured asset
allocation strategy ideally suited to his or her management goals.
4. Integrated Asset Allocation:

✓ With integrated asset allocation, you consider both your economic
expectations and your risk in establishing an asset mix.
✓ While all of the above-mentioned strategies take into account
expectations for future market returns, not all of the strategies account
for investment risk tolerance.
✓ Integrated asset allocation, on the other hand, includes aspects of all
strategies, accounting not only for expectations but also actual
changes in capital markets and your risk tolerance.
✓ Integrated asset allocation is a broader asset allocation strategy, albeit
allowing only either dynamic or constant-weighting allocation.
Obviously, an investor would not wish to implement two strategies
that compete with one another.
Page 59
Q41. Explain the process involved in fixed income portfolio.

Answer:
Fixed Income Portfolio
Fixed Income Portfolio is same as equity portfolio with difference that it
consist of fixed income securities such as bonds, debentures, money market
instruments etc. Since, it mainly consists of bonds, it is also called Bond
Portfolio.
Just like other portfolios, following five steps are involved in fixed income
portfolio.
1. Setting up objective
2. Drafting guideline for investment policy
3. Selection of Portfolio Strategy - Active and Passive
4. Selection of securities and other assets
5. Evaluation of performance with benchmark
Q42. What methods are involved to calculate the return of fixed income
portfolio?
Answer:
First and foremost step in evaluation of performance of a portfolio is calculation
of return. Although there can be many types of measuring returns there can be
many types of measuring returns as per requirements but some of are commonly
used measures are :
1. Arithmetic Average Rate of Return
 It is computed as the sum of all the numbers in the series divided by the
count of all numbers in the series. The arithmetic mean is sometimes
referred to as the average or simply as the mean
 Suppose you wanted to know what the arithmetic mean of a stock's closing
price was over the past week. If the stock closed at $14.50, $14.80, $15.20,
$15.50 and then $14, its arithmetic mean closing price would be equal to
the sum of the five numbers, $74, divided by 5, or $14.80.
Note: Formulas or Practical Questions on the return on Fixed Income Portfolio is not a part of the syllabus.
However it is recommended to go through topics once along with examples
Page 60
2. Time Weighted Rate of Return

✓ The time-weighted rate of return is a measure of the compound rate of
growth in a portfolio.
✓ This is also called the geometric mean return, as the reinvestment is
captured by using the geometric total and mean, rather than the
arithmetic total and mean.
✓ It is assumed that all cash distributions are reinvested in the portfolio
and the exact same periods are used for comparisons.
✓ Consider the following two investor scenarios:
Investor 1 invests $1 million into Mutual Fund A on December 31. On
August 15 of the following year, his portfolio is valued at $1,162,484.
At that point, he adds $100,000 to Mutual Fund A, bringing the total
value to $1,262,484. By the end of the year, the portfolio has decreased
in value to $1,192,328.
The first period return, from December 31 to August 15, would be
calculated as follows:
Return = ($1,162,484 - $1,000,000) / $1,000,000 = 16.25%
The second period return, from August 15 to December 31, would be
calculated as:
Return = ($1,192,328 - ($1,162,484 + $100,000)) / ($1,162,484 +
$100,000) = -5.56%
The time-weighted over the two time periods is calculated by
geometrically linking these two returns as follows:
Time-weighted return = (1 + 16.25%) x (1 + (-5.56%)) - 1 = 9.79%
Investor 2 invests $1 million into Mutual Fund a on December 31. On
August 15 of the following year, her portfolio is valued at $1,162,484.
At that point, she withdraws $100,000 from Mutual Fund A, bringing
the total value down to $1,062,484. By the end of the year the portfolio
has decreased in value to $1,003,440.
The first period return, from December 31 to August 15, would be
calculated as follows:
Return = ($1,162,484 - $1,000,000) / $1,000,000 = 16.25%
Page 61
The second period return, from August 15 to December 31, would be

calculated as:
Return = ($1,003,440 - ($1,162,484 - $100,000)) / ($1,162,484 -
$100,000) = -5.56%
The time-weighted over the two time periods is calculated by
geometrically linking these two returns as follows:
Time-weighted return = (1 + 16.25%) x (1 + (-5.56%)) - 1 = 9.79%
As expected, both investors received the same 9.79% time-weighted
return, even though one added money and the other withdrew money.
Eliminating the cash flow effects is precisely why time-weighted return
is an important concept that allows investors to compare the investment
returns of their portfolios and any financial product.
3. Rupee (Money) Weighted Rate of Return

✓ A money-weighted rate of return is a measure of the rate of return for an
asset or portfolio of assets.
✓ It is calculated by finding the rate of return that will set the present values of
all cash flows and terminal values equal to the value of the initial
investment.
✓ The money-weighted rate of return is equivalent to the internal rate of
return (IRR).
4. Annualized Return
An annualized total return is the geometric average amount of money earned
by an investment each year over a given time period. It is calculated as a
geometric average to show what an investor would earn over a period of time
if the annual return was compounded
For example, assume a mutual fund was held by an investor for 575 days and
earned a cumulative return of 23.74%. The annualized return would be:
Annualized Return = (1 + 23.74%) ^ (365 / 575) - 1 = 114.5% - 1 = 14.5%
Page 62
Q43. Discuss about the fixed income portfolio management strategy.

Answer:
There are two strategies
1. Passive Strategy
2. Active Strategy
1. Passive Strategy
(i) Buy and Hold Strategy: This technique is do nothing technique and
investor continues with initial selection and do not attempt to churn
bond portfolio to increase return or reduce the level of risk. However,
sometime to control the interest rate risk, the investor may set the
duration of fixed income portfolio equal to benchmarked index.
(ii) Indexation Strategy: This strategy involves replication of a
predetermined benchmark well known bond index as closely as
possible.
(iii) Immunization: This strategy cannot exactly be termed as purely
passive strategy but a hybrid strategy. This strategy is more popular
among pension funds. Since pension funds promised to pay fixed
amount to retires people in the form of annuities any inverse
movement in interest may threaten fund’s ability to meet their
liability timely. By building an immunized portfolio the interest rate
risk can be avoided.
(iv) Matching Cash Flows: Another stable approach to immunize the
portfolio is Cash Flow Matching. This approach involves buying of
Zero Coupon Bonds to meet the promised payment out of the
proceeds realized.
2. Active Strategy
As mentioned earlier active strategy is usually adopted to outperform the
market. Following are some of active strategies:
1. Forecasting Returns and Interest Rates:
This strategy invokes the estimation of return on basis of change in
interest rates. Since interest rate and bond values are inversely related
if portfolio manager is expecting a fall in interest rate of bonds he/she
should buy with longer maturity period. On the contrary, if he/she
Page 63
expected a fall in interest then he/she should sell bonds with longer
period.
Based on short term yield movement following three strategies can be
adopted:
 Bullet Strategies
 Barbell Strategies
 Ladder Strategies
Further estimation of interest ratio is a daunting task, and quite difficult
to ascertain. There are several models available to forecast the expected
interest rates which are based on:
1. Inflation
2. Past Trends
3. Multi Factor Analysis
It should be noted that these models can be used as estimates only, as
it is difficult to calculate the accurate changes.
There is one another techniques of estimating expected change in
interest rate called ‘Horizon Analysis’. This technique requires that
analyst should select a particular holding period and then predict yield
curve at the end of that period as with a given period of maturity, a bond
yield curve of a selected period can be estimated and its end price can
also be calculated
1. Bond Swaps: This strategy involves regularly monitoring bond process to
identify mispricing and try to exploit this situation. Some of the popular
swap techniques are as follows:
2. Pure Yield Pickup Swap - This strategy involves switch from a lower
yield bond to a higher yield bonds of almost identical quantity and
maturity. This strategy is suitable for portfolio manager who is willing to
assume interest rate risk as in switching from short term bond to long term
bonds to earn higher rate of interest, he may suffer a capital loss.
3. Substitution Swap - This swapping involves swapping with similar type
of bonds in terms of coupon rate, maturity period, credit rating, liquidity
and call provision but with different prices. This type of differences exits
due to temporary imbalance in the market. The risk a portfolio manager
Page 64
carries if some features of swapped bonds may not be truly identical to

the swapped one.
4. International Spread Swap – In this swap portfolio manager is of the
belief that yield spreads between two sectors is temporarily out of line and
he tries to take benefit of this mismatch. Since the spread depends on
many factor and a portfolio manager can anticipate appropriate strategy
and can profit from these expected differentials.
5. Tax Swap – This is based on taking tax advantage by selling existing bond
whose price decreased at capital loss and set it off against capital gain in
other securities and buying another security which has features like that
of disposed one.
6. Interest Rate Swap: Interest Rate Swap is another technique that is used
by Portfolio Manager. This technique has been discussed in greater details
in the chapter on Derivative.
Q44. What is Alternative Investment?

Answer:
An alternative investment is an asset that is not one of the conventional
investment types, such as stocks, bonds and cash.
✓ Most alternative investment assets are held by institutional investors or
accredited, high-net-worth individuals because of the complex natures and
limited regulations of the investments.
✓ Alternative investments include private equity, hedge funds, managed
futures, real estate, commodities and derivatives contracts
Page 65
Q45. What are the features or characteristics of Alternative Investment?

Answer:
Though here may be many features of Alternative Investment but following are
some common features.
1. High Fees – Being a specific nature product the transaction fees are quite
on higher side.
2. Limited Historical Rate – The data for historic return and risk is verity
limited where data for equity market for more than 100 years in available.
3. Illiquidity – The liquidity of Alternative Investment is not good as next
buyer not be easily available due to limited market.
4. Less Transparency – The level of transparency is not adequate due to
limited public information available.
5. Extensive Research Required – Due to limited availability of market
information the extensive analysis is required by the Portfolio Managers.
6. Leveraged Buying – Generally investment in alternative investments is
highly leveraged.
Q46. What are the different types of Alternative Investments?

Answer:
Over the time various types of AIs have been evolved but some of the
important AIs are as follows:
1. Mutual Funds
2. Real Estates
3. Exchange Traded Funds
4. Private Equity
5. Hedge Funds
6. Closely Held Companies
7. Distressed Securities
8. Commodities
9. Managed Futures
10. Mezzanine Finance
Page 66
Q47. What makes the Real Estate Valuation complex?

Answer:
Comparing to financial instrument the valuation of Real Estate is quite complex
as number of transactions or dealings comparing to financial instruments are
very small.
Following are some characteristics that make valuation of Real Estate quite
complex:
1. Inefficient market: Information as may not be freely available as in case
of financial securities.
2. Illiquidity: Real Estates are not as liquid as that of financial instruments.
3. Comparison: Real estates are only approximately comparable to other
properties.
4. High Transaction cost: In comparison to financial instruments, the
transaction and management cost of Real Estate is quite high.
5. No Organized market: There is no such organized exchange or market
as for equity shares and bonds.
Q48. What approaches are used for Real Estate Valuation?

Answer:
Generally, following four approaches are used in valuation of Real estates:
(1) Sales Comparison Approach – It is like Price Earning Multiplier as in
case of equity shares. Benchmark value of similar type of property can
be used to value Real Estate.
(2) Income Approach – This approach like value of Perpetual Debenture
or unredeemable Preference Shares. In this approach the perpetual cash
flow of potential net income (after deducting expense) is discounted at
market required rate of return.
(3) Cost Approach – In this approach, the cost is estimated to replace the
building in its present form plus estimated value of land. However,
adjustment of other factors such as good location, neighborhood is also
made in it.
Page 67
(4) Discounted After Tax Cash Flow Approach – In comparison to NPV

technique, PV of expected inflows at required rate of return is reduced
by amount of investment.
Q49. What is Mezzanine Finance?

Answer:
✓ It is a blend or hybrid of long term debt and equity share.
✓ It is a kind of equity funding combined with the characteristics of
conventional lending as well as equity.
✓ This is a highly risky investment and hence mezzanine financer receives
higher return.
✓ This type of financing enhances the base of equity as in case of default
the debt is converted into equity.
✓ Mezzanine financing can be used for financing heavy investments,
buyout, temporary arrangement between sanction of heavy loan and its
disbursement.
✓ However, compared to western world, this type of financing is not so
popular in India.
Q50. What is Venture Capital Fund?

Answer:
Venture capital means funds made available for startup firms and small
businesses with exceptional growth potential. Venture capital is money
provided by professionals who alongside management invest in young, rapidly
growing companies that have the potential to develop into significant economic
contributors.
Venture Capitalists generally:
✓ Finance new and rapidly growing companies
✓ Purchase equity securities
✓ Assist in the development of new products or services
✓ Add value to the company through active participation.
Page 68
Q51. What are the characteristics of venture capital fund?

Answer:
1. Long time horizon: The fund would invest with a long time horizon in
mind. Minimum period of investment would be 3 years and maximum
period can be 10 years.
2. Lack of liquidity: When VC invests, it takes into account the liquidity
factor. It assumes that there would be less liquidity on the equity it gets
and accordingly it would be investing in that format. They adjust this
liquidity premium against the price and required return.
3. High Risk: VC would not hesitate to take risk. It works on principle of high
risk and high return. So higher riskiness would not eliminate the investment
choice for a venture capital.
4. Equity Participation: Most of the time, VC would be investing in the form
of equity of a company. This would help the VC participate in the
management and help the company grow.
Q52. What are the advantages of bringing venture capital into the
company?
Answer:
✓ It injects long- term equity finance which provides a solid capital base for
future growth.
✓ The venture capitalist is a business partner, sharing both the risks and
rewards. Venture capitalists are rewarded with business success and
capital gain.
✓ The venture capitalist is able to provide practical advice and assistance to
the company based on past experience with other companies which were
in similar situations.
✓ The venture capitalist also has a network of contacts in many areas that
can add value to the company.
✓ The venture capitalist may be capable of providing additional rounds of
funding should it be required to finance growth.
Page 69
✓ Venture capitalists are experienced in the process of preparing a company

for an initial public offering (IPO) of its shares onto the stock exchanges
or overseas stock exchange such as NASDAQ.
✓ They can also facilitate a trade sale.
Q53. Discuss the stages of funding in Venture Capital Finance.

Answer:
1. Seed Money: Low level financing needed to prove a new idea.
2. Start-up: Early stage firms that need funding for expenses associated with
marketing and product development.
3. First-Round: Early sales and manufacturing funds.
4. Second-Round: Working capital for early stage companies that are selling
product, but not yet turning in a profit.
5. Third Round: Also called Mezzanine financing, this is expansion money
for a newly profitable company
6. Fourth-Round: Also called bridge financing, it is intended to finance the
"going public" process
Q54. Discuss the venture capital investment process.

Answer:
The entire VC Investment process can be segregated into the following steps:
1. Deal Origination: VC operates directly or through intermediaries. Mainly
many practicing Chartered Accountants would work as intermediary and
through them VC gets the deal.
Before sourcing the deal, the VC would inform the intermediary or its
employees about the following so that the sourcing entity does not waste
time:
✓ Sector focus
✓ Stages of business focus
✓ Promoter focus
✓ Turn over focus
Page 70
Here the company would give a detailed business plan which consists of
business model, financial plan and exit plan. All these aspects are covered
in a document which is called Investment Memorandum (IM). A tentative
valuation is also carried out in the IM.
2. Screening: Once the deal is sourced the same would be sent for screening
by the VC. The screening is generally carried out by a committee consisting
of senior level people of the VC. Once the screening happens, it would
select the company for further processing.
3. Due Diligence: The screening decision would take place based on the
information provided by the company. Once the decision is taken to
proceed further, the VC would now carry out due diligence. This is mainly
the process by which the VC would try to verify the veracity of the
documents taken. This is generally handled by external bodies, mainly
renowned consultants. The fees of due diligence are generally paid by the
VC.
However, in many case this can be shared between the investor (VC) and
Investee (the company) depending on the veracity of the document
agreement.
4. Deal Structuring: Once the case passes through the due diligence it would
now go through the deal structuring. The deal is structured in such a way
that both parties win. In many cases, the convertible structure is brought in
to ensure that the promoter retains the right to buy back the share. Besides,
in many structures to facilitate the exit, the VC may put a condition that
promoter has also to sell part of its stake along with the VC. Such a clause
is called tag- along clause.
5. Post Investment Activity: In this section, the VC nominates its nominee in

the board of the company. The company has to adhere to certain guidelines
like strong MIS, strong budgeting system, strong corporate governance and
other covenants of the VC and periodically keep the VC updated about
certain mile-stones. If milestone has not been met the company has to give
explanation to the VC. Besides, VC would also ensure that professional
management is set up in the company.
Page 71
6. Exit plan: At the time of investing, the VC would ask the promoter or
company to spell out in detail the exit plan. Mainly, exit happens in two
ways: one way is ‘sell to third paty(ies)’ . This sale can be in the form of
IPO or Private Placement to other VCs. The second way to exit is that
promoter would give a buy back commitment at a pre- agreed rate
(generally between IRR of 18% to 25%). In case the exit is not happening
in the form of IPO or third party sell, the promoter would buy back. In many
deals, the promoter buyback is the first refusal method adopted i.e. the
promoter would get the first right of buyback.
Q55. What is distressed securities?

Answer:
✓ It is a kind of purchasing the securities of companies that are in or near
bankruptcy.
✓ Since these securities are available at very low price, the main purpose of
buying such securities is to make efforts to revive the sick company.
✓ Further, these securities are suitable for those investors who cannot
participate in the market and those who wants avoid due diligence.
✓ Now, question arises how profit can be earned from distressed securities.
We can see by taking long position in debt and short position in equity,
how investor can earn arbitrage profit.
1. In case company’s condition improves because of priority, the investor
will get his interest payment which shall be more than the dividend on
his short position in equity shares.
2. If company is condition further deteriorates the value of both share ad
debenture goes down. He will make good profit from his short
position.
Page 72
Q56. What types of risk has to be analyzed before investing in distressed

securities?
Answer:
On the face, investment in distressed securities appears to be a good proposition
but following types of risks are need to be analyzed.
1. Liquidity Risk – These securities may be saleable in the market.
2. Event Risk – Any event that particularly effect the company not economy
as a whole
3. Market Risk – This is another type of risk though it is not important.
4. Human Risk – The judge’s decision on the company in distress also play
a big role.
Page 73
Practical Questions
1. Investor has assigned the probability of occurrence of the possible alternative
returns. Find out the expected return.
Possible returns Probability
20% 0.20
30% 0.20
50% 0.40
60% 0.10
70% 0.10
2. Calculate the variance and standard deviation considering the data given below
Possible returns Probability
20% 0.20
30% 0.20
50% 0.40
60% 0.10
70% 0.10
3. A stock costing `150 pays no dividends. The possible prices that the stock
might sell for at the end of the year with the respective probabilities are:
Price Probability
130 0.2
150 0.1
160 0.1
165 0.3
175 0.1
180 0.2
Total 1
Required:
(i) Calculate the expected return.
(ii) Calculate the Standard deviation of returns.
Page 74
4. The market price of an equity share is `100. Following information is available

in respect of dividends, market price and the expected market condition after
one year:
Market condition Probability Market Price Dividend

Good 0.25 115 9
Normal 0.50 107 5
Bad 0.25 97 3
Find out the expected return and variability of returns of the equity share.
5. Stock of Reliance has beta of 1.2. Find out the movement in stock if
a. Market moves up by 12%
b. Market decline by 10%
6. The distribution of return of security ‘F’ and the market portfolio ‘P’ is given
below:
Probability Return %
F P
0.3 30 -10
0.4 20 20
0.3 0 30
You are required to calculate the expected return of security ‘F’ and the
market portfolio ‘P’, the covariance between the market portfolio and
security and beta for the security.
---------------------------------[May 2006, 8 Marks] --------------------------------
Page 75
7. The historical rates of return of two securities over the past ten years are
given. Calculate the beta of the security 1 and assume security 2 returns are
market returns
Years: 1 2 3 4 5 6 7 8 9 10
Security 1: 12 8 7 14 16 15 18 20 16 22
(Return per cent)
Security 2: 20 22 24 18 15 20 24 25 22 20
(Return per cent)
--------------------------------[May 2007, 10 Marks] --------------------------------
8. The expected returns and standard deviation for two investments are as follows:
A B
a. Expected return 12% 20%
b. Standard Deviation 9% 10%
Advise the investor
9. Ashok Rai has a portfolio of five securities whose expected return and amount
invested are as follows
I II III IV V
Amount (in Lakhs) 1.5 2.5 3.0 1.0 2.0
Expected Return 12% 9% 15% 18% 14%
Find out the % expected return of the portfolio.
10. Let us consider a portfolio of two equity shares A and B with expected returns
of 16% and 22% respectively. If 40% of total funds is invested in the share of
A and rest in B then what will be the expected portfolio return?
Page 76
11. Following information is available in respect of the rate or return available of

two securities A and B in different economic conditions.
Condition Prob. Rate of Return
A B
Recession 0.20 -0.15 0.20
Normal 0.50 0.20 0.30
Boom 0.30 0.60 0.40
Find out the expected returns and the standard deviation for these two
securities. Suppose an investor has `20,000 to invest. He invests `15,000 in
security A and balance in Security B, what will be the expected return of the
portfolio?
12. Standard deviation of security A=40

Standard deviation of security B=20
Proportion of investment in A=0.4 and in B=0.6
Calculate the standard deviation of portfolio when correlation coefficient is
i) 1
ii) -1
iii) 0
13. Consider the following data

A B
𝑟̅ 20% 25%
𝜎 50% 30%
𝑟𝑎𝑏 -0.60
Now suppose the portfolio is constructed with 40% of the funds invested in A
and balance 60% in B
Page 77
You are required to calculate:

a. Expected Return of the portfolio
b. Variance of the portfolio
c. Standard deviation of the portfolio
d. State whether diversification has resulted in reduction of risk?
14. Following is the data regarding six securities:

A B C D E F
Return (%) 8 8 12 4 9 8
Risk (%) (Standard Deviation) 4 5 12 4 5 6
i. Which of the securities will be selected?
ii. Assuming perfect correlation, analyse whether it is preferable to
invest 75% in security A and 25% in security C.
-------------------------------[Nov 1996, 8 Marks] -----------------------------------
15. X Co., Ltd., invested on 1.4.2005 in certain equity shares as below:
Name of Co. No. of Shares Cost(`)

M Ltd. 1,000 (`100 each) 2,00,000
N Ltd 500 (`10 each) 1,50,000
In September, 2005, 10% dividend was paid out by M Ltd. and in October,
2005, 30% dividend paid out by N Ltd. On 31.3.2006 market quotations
showed a value of `220 and `290 per share for M Ltd. and N Ltd.
respectively.
On 1.4.2006, investment advisors indicate (a) that the dividends from M Ltd.
and N Ltd. for the year ending 31.3.2007 are likely to be 20% and 35%,
respectively and (b) that the probabilities of market quotations on 31.3.2007
are as below:
Page 78
Probability Price/share of M Price/share of N

0.2
factor 220
Ltd. 290
Ltd.
0.5 250 310
0.3 280 330
You are required to:

1. Calculate the average return from the portfolio for the year ended
31.3.2006;
2. Calculate the expected average return from the portfolio for the year
2006-07;
3. Advise X Co. Ltd., of the comparative risk in the two investments
by calculating the standard deviation in each case.
----------------[May 2008, 8 Marks]---------[Nov 2006, 8 Marks]---------------
16. Mr. A is interested to invest `1,00,000 in the securities market. He selected

two securities B and D for this purpose. The risk return profile of these
securities are as follows:
Security Risk ( %) Expected Return
B 10% 12%
(ER)
D 18% 20%
Co-efficient of correlation between B and D is 0.15.
You are required to calculate the portfolio return of the following
portfolios of B and D to be considered by A for his investment.
(i) 100 percent investment in B only;
(ii) 50 percent of the fund in B and the rest 50 percent in D;
(iii) 75 percent of the fund in B and the rest 25 percent in D; and
(iv) 100 percent investment in D only.
Also indicate that which portfolio is best for him from risk as well as return
point of view?
-------------------[Nov 2008, 8 Marks] ------[May 2018, 10 Marks]--------------
Page 79
17. Calculate the risk of the following multiple asset portfolio

Security 𝑋𝑖 𝜎𝑖 Correlation
coefficient
X 0.25 16 X and Y = 0.7
Y 0.35 7 X and Z = 0.3
Z 0.40 9 Y and Z = 0.4
It may be noted that the correlation coefficient between X and X, Y and Y, Z
and Z is 1.
18. Mr. X is holding a portfolio with expected return of 20% and standard
deviation of 24%. He now inherits a portfolio which has the expected return
and standard deviation of 14% and 18% respectively. The market values of
two portfolios are in the ratio of 2:3. Find out the expected return and standard
deviation of the combined portfolio of Mr.X, given the correlation coefficient
of 0.6.
19. A Portfolio Manager (PM) has the following four stocks in his portfolio:
Security No. Of Shares Market Price per share (`) 𝜷
VSL 10,000 50 0.9

CSL 5,000 20 1.0
SML 8,000 25 1.5
APL 2,000 200 1.2
Compute the following:
i. Portfolio Beta
ii. If the PM seeks to reduce the beta to 0.8, how much risk free
investment should he bring in?
iii. If the PM seeks to increase the beta to 1.2, how much risk free
investment should he bring in?
------------------------------[Nov 2011, 8 Marks] -------------------------------------
Page 80
20. A company has a choice of investments between several different equity

oriented mutual funds. The company has an amount of `1 crore to invest.
The details of the mutual funds are as follows:
Mutual Fund Beta
A 1.6
B 1.0
C 0.9
D 2.0
E 0.6
Required:
i. If the company invests 20% of its investment in the first two
mutual funds and an equal amount in the mutual funds C, D and
E, what is the beta of the portfolio?
ii. If the company invests 15% of its investment in C, 15% in A, 10%
in E and the balance in equal amount in the other two mutual funds,
what is the beta of the portfolio?
iii. If the expected return of market portfolio is 12% at a beta factor
of 1.0, what will be the portfolios expected return in both the
situations given above?
---------------------[May 2008, 10 Marks] –[RTP Nov 2016]--------------------
21. Consider the following information on two stocks, A and B:

Year Return on A (%) Return on B (%)
2006 10 12
2007 16 18
You are required to determine

(i) The expected return on a portfolio containing A and B in the proportion
of 40% and 60% respectively.
(ii) The standard deviation of return from each of the two stocks.
Page 81
(iii) The covariance of returns from the two stocks.

(iv) Correlation coefficient between the returns of the two stocks.
(v) The risk of a portfolio containing A and B in the proportion of 40% and
60%.
-------------------------------[Nov 2008, 5 Marks] ----------------------------------
22. An investor has decided to invest to invest `1,00,000 in the shares of two
companies, namely, ABC and XYZ. The projections of returns from the shares
of the two companies along with their probabilities are as follows:
Probability ABC(%) XYZ(%)
0.20 12 16
0.25 14 10
0.25 -7 28
0.30 28 -2
You are required to
1. Comment on return and risk of investment in individual shares.
2. Compare the risk and return of these two shares with a Portfolio of these
shares in equal proportions.
3. Find out the proportion of each of the above shares to formulate a
minimum risk portfolio.
23. A two-asset portfolio contains a long position in commodity (T) with volatility
of 10.0% and a long position in stock (S) with volatility of 30.0%. The assets
are uncorrelated: r(T,S) = zero (0). What weight (0 to 100%) of the portfolio
should be allocated to the commodity if the goal is a minimum variance
portfolio (in percentage terms, as no dollars are introduced)?
Page 82
24. Treasury bills give a return of 5%. Market return is 13%

i) What is the market risk premium?
ii) Compute the 𝛽 value and required returns for the following combination
of investments.
Treasury Bills 100 70 30 0
Market 0 30 70 100
25. The returns and beta of 3 stocks are given below

Stock A B C
Return (%) 18 11 15
Beta Factor 1.7 0.6 1.2
If the risk free rate is 9% and the expected rate of return on the market portfolio
is 14% which of the above stocks are over, under, or correctly valued in the
market? What shall be the strategy?
26. The following information is available in respect of Security X

Equilibrium Return 15%
Market Return 15%
7% Treasury Bonds trading at $140
Covariance of Market return and security Return 225%
Coefficient of Correlation 0.75
You are required to determine the Standard Deviation of Market Return and
Security Return.
27. A security has a standard deviation of 2.8%. The correlation coefficient of the
security with the market is 0.8 and standard deviation of the market return is
2.3%, the return from government securities is 12% and from the market
portfolio is 18%. What is the required return on the security.
Page 83
28. Mr. Tempest has the following portfolio of four shares:

Name Beta Investment in `Lac
Oxy Rin Ltd. 0.45 0.80
Boxed Ltd. 0.35 1.50
Square Ltd. 1.15 2.25
Ellipse Ltd. 1.85 4.50
The risk free rate of return is 7% and the market rate of return is 14%
Required:
(i) Determine the portfolio return.
(ii) Calculate the portfolio Beta.
----------------------------[May 2011, 5 Marks] --------------------------------------
29. Pearl ltd. expects that considering the current market prices, the equity
shareholders should get a return of at least 15.50% while the current return on
the market is 12%. RBI has closed the latest auction for `2500 crores for 182
day bills for the lowest bid of 4.3% although there were bidders at a higher rate
of 4.6% also for lots of less than `10 crores. What is Pearl ltd’s beta?
30. A Company pays a dividend of `2.00 per share with a growth rate of 7%. The
risk free rate is 9% and the market rate of return is 13%. The Company has a
beta factor of 1.50. However, due to a decision of the Finance Manager, beta
is likely to increase to 1.75. Find out the present as well as the likely value of
the share after the decision.
31. XYZ Ltd. paid a dividend of `2 for the current year. The dividend is expected
to grow at 40% for the next 5 years and at 15% per annum thereafter. The
return on 182 days T-bills is 11% per annum and the market return is expected
to be around 18% with a variance of 24%. The co-variance of XYZ's return
with that of the market is 30%. You are required to calculate the required rate
of return and intrinsic value of the stock.
Page 84
32. The following information is available with respect to Jaykay Ltd.

Jaykay Limited Market
Return on
Average
Year Average Dividend govt.
share DPS
Index yield bonds
price
2002 242 20 1812 4% 6%
2003 279 25 1950 5% 5%
2004 305 30 2258 6% 4%
2005 322 35 2220 7% 5%
Compute beta value of the company as at the end of 2005? What is your
observation?
33. A Ltd. has an expected return of 22% and Standard deviation of 40%. B
Ltd. has an expected return of 24% and Standard deviation of 38%. A Ltd.
has a beta of 0.86 and B Ltd. a beta of 1.24. The correlation coefficient
between the return of A Ltd. and B Ltd. is 0.72. The Standard deviation of
the market return is 20%. Suggest:
i. Is investing in B Ltd. better than investing in A Ltd.?
ii. If you invest 30% in B Ltd. and 70% in A ltd., what is your expected
rate of return and portfolio Standard deviation?
iii. What is the market portfolios expected rate of return and how much is
the risk-free rate?
iv. What is the beta of Portfolio if A Ltd.’s weight is 70% and B Ltd.’s
weight is 30%?
------------------------------[May 2002, 10 Marks] ---------------------------------
Page 85
34. The total market value of the equity share of O.R.E. Company is `60,00,000
and the total value of the debt is `40,00,000. The treasurer estimate that the
beta of the stock is currently 1.5 and that the expected risk premium on the
market is 10 per cent. The treasury bill rate is 8 per cent.
Required:
(1) What is the beta of the Company’s existing portfolio of assets?
(2) Estimate the Company’s Cost of capital and the discount rate for an
expansion of the company’s present business.
35. XYZ Ltd. has substantial cash flow and until the surplus funds are utilised to
meet the future capital expenditure, likely to happen after several
months, are invested in a portfolio of short-term equity investments, details for
which are given below:
Investment No. of Beta Market price per Expected dividend
shares share yield
I 60000 1.16 4.29 19.50%
II 80000 2.28 2.92 24.00%
III 100000 0.90 2.17 17.50%
IV 125000 1.50 3.14 26.00%
The current market return is 19% and the risk free rate is 11%.
Required to:
(i) Calculate the risk of XYZ’s short-term investment portfolio relative to
that of the market;
(ii) Whether XYZ should change the composition of its portfolio.
----------------------------------[May 2007, 8 Marks] --------------------------------
Page 86
36. A holds the following portfolio:

Share/Bond Beta Initial Price Dividends Market Price at end of year
Epsilon Ltd. 0.8 25 2 50
Sigma Ltd. 0.7 35 2 60
Omega Ltd. 0.5 45 2 135
GOI Bonds 0.01 1000 140 1005
Risk-free return is 14%.
Calculate:
(i) The expected rate of return on his portfolio using Capital Asset Pricing
Method (CAPM)
(ii) The average return of his portfolio.
37. Mr. FedUp wants to invest an amount of `520 lakhs and had approached his
portfolio manager. The portfolio manager had advised Mr. FedUp to invest in
the following manner:
Security Moderate Better Good Very Best
Good
Amount in `Lakhs 60 80 100 120 160
Beta 0.5 1.00 0.80 1.20 1.50
You are required to advise Mr.FedUp in regard to the following using Capital
Asset Pricing Methodology:
(i) Expected return on the portfolio, if the Government securities are at 8%
and the NIFTY is yielding 10%
(ii) Advisability of replacing Security “Better” with NIFTY.
------------------------------[Nov 2012, 8 Marks] ------------------------------------
Page 87
38. An investor is holding 1,000 shares of Fatlass Company. Presently the rate
of dividend be ing paid by the company is `2 per share and the share is being
sold at `25 per share in the market. However, several factors are likely to
change during the course of the year as indicated below:
Existing Revised
Risk free rate 12% 10%
Market risk premium 6% 4%
Beta value 1.4 1.25
Expected growth rate 5% 9%
In view of the above factors whether the investor should buy, hold or sell
the shares? And why?
------------------------------ [May 2003, 8 Marks] ----------------------------------
39. An investor is holding 5,000 shares of X Ltd. Current year dividend rate is `3/
share. Market price of the share is `40 each. The investor is concerned about
several factors which are likely to change during the next financial year as
indicated below:
Current Year Next Year

Dividend Paid/
Anticipated per share 3 2.5
Risk free rate 12% 10%
Market risk premium 5% 4%
Beta value 1.3 1.4
Expected growth rate 9% 7%
In view of the above, advise whether the investor should buy, hold or sell the
shares of X Ltd.
Page 88
40. Calculate the market sensitivity index and the expected return on the investment
from the following data:
Standard deviation of an asset 2.5%
Market standard deviation 2.0%
Risk free rate of return 13.0%
Expected return on market portfolio 15.0%
Correlation coefficient of portfolio with market 0.8
What will be the expected return on the portfolio if portfolio beta is 0.5 and
the risk free return is 10%.
41. You are presented with the following information concerning the returns on
the shares of C Ltd. and on the market portfolio, according to the various
conditions of the economy.
Condition of Prob. of Returns on Returns on
economy condition C Ltd. Market
1 0.2 15% 10%
2 0.4 14% 16%
3 0.4 26% 24%
The current risk free interest rate is 9%
Required:
(a) Calculate the coefficient of correlation between the returns on C ltd. and
the market portfolio.
(b) Calculate the total risk (i.e. standard deviation) of C Ltd. and discuss why
this is not the most appropriate measure of risk to be used in making
investment decisions.
(c) Calculate the beta factor for C Ltd. and briefly discuss its significance.
Is C Ltd. efficiently priced according to the CAPM and the information
given above?
Page 89
42. The following information is available in respect of securities A and B

Security β Expected Return Risk
Premium
A 0.50 NA 4%
B 1.75 20% NA
On the basis of this information find out whether the following securities are
overpriced or underpriced:
Security β Expected Return
I 2.0 20%
II 0.75 14%
III 1.25 15%
IV -0.25 5%
V 3.25 31%
43. An investor holds two stocks A and B. An analyst prepared ex-ante probability
distribution for the possible economic scenarios and the conditional returns for
two stocks and the market index as shown below:
Economic scenario Probability Conditional
Returns%
A B Market
Growth 0.40 25 20 18
Stagnation 0.30 10 15 13
Recession 0.30 -5 -8 -3
The risk free rate during the next year is expected to be around 11%.
Determine whether the investor should liquidate his holdings in stocks A and
B or on the contrary make fresh investments in them. CAPM assumptions are
holding true.
-------------------------------[June 2009, 10 Marks] --------------------------------
Page 90
44. Mr. Tamarind intends to invest in equity shares of a company the value of
which depends upon various parameters as mentioned below:
Factor Beta Expected Actual
value in % value in %
GNP 1.20 7.70 7.70
Inflation 1.75 5.50 7.00
Interest Rate 1.30 7.75 9.00
Stock Market Index 1.70 10.00 12.00
Industrial Production 1.00 7.00 7.50
If the risk free rate of interest be 9.25%, how much is the return of the share
under Arbitrage Pricing Theory?
----------------------------[May 2011, 5 Marks] --------------------------------------
45. Mr. X owns a portfolio with the following characteristics
Security A Security B Risk free security

Factor 1 sensitivity 0.80 1.50 0
Factor 2 sensitivity 0.60 1.20 0
Expected Return 15% 20% 10%
It is assumed that security returns are generated by a two factor model.
II. If Mr. X has `1,00,000 to invest and sells short `50,000 of security B and
purchases `1,50,000 of security A, what is the sensitivity of Mr. X’s
portfolio to the two factors?
III. If Mr.X borrows `1,00,000 at the risk free rate and invests the amount he
borrows along with the original amount of `1,00,000 in security A and
B in the same proportion as described in part (i), what is the sensitivity
of the portfolio to the two factors?
IV. What is the expected return premium of factor 2?
Page 91
----------------------[Jun 2009, 8 Marks]------[Nov 2018, 8 Marks]------------

-
46. Mr. Nirmal Kumar has categorized all the available stock in the market into
the following types:
i. Small cap growth stocks
ii. Small cap value stocks
iii. Large cap growth stocks
iv. Large cap value stocks
Mr.Nirmal Kumar also estimated the weights of the above categories of stocks
in the market index. Further, more the sensitivity of returns on these categories
of stocks to the three important factor are estimated to be:
Category of the stock Weight in the Factor I Factor II Factor III

market index (Beta) (book price) (Inflation )
Small cap growth 25% 0.80 1.39 1.35
Small cap value 10% 0.90 0.75 1.25
Large cap growth 50% 1.165 2.25 8.65
Large cap value 15% 0.85 2.05 6.75
Risk Premium 6.85% -3.5% 0.65%
The rate of return on treasury bonds is 4.5%
Required:
a) Using Arbitrage Pricing Theory, determine the expected return on the

market index.
b) Using Capital Asset Pricing Model (CAPM), determine the expected
return on the market index.
c) Mr. Nirmal Kumar wants to construct a portfolio constituting only the
‘small cap value’ and ‘large cap growth’ stocks. If the target beta for the
desired portfolio is 1, determine the composition of his portfolio.
Page 92
47. Mr. X has a portfolio which has 𝜶 of 2.9% and 𝜷 of 0.9. Expected return of
the market portfolio is 18%. Find out the expected return of the portfolio.
48. A portfolio has been constructed with the following features

Security 𝜷 Random Error 𝝈𝒆𝒊 Weight
A 1.50 6 0.3
B 1.10 10 0.2
C 1.30 4 0.2
D 0.80 12 0.2
E 0.90 7 0.1
Find out the risk of the portfolio given that the standard deviation of the
market index is 20%.
49. A study by a Mutual fund has revealed the following data in respect of three
securities:
Security 𝝈(%) correlation with Index, Pm

A 20 0.60
B 18 0.95
C 12 0.75
The standard deviation of market portfolio (BSE Sensex) is observed to be
15%.
(i) What is the sensitivity of returns of each stock with respect to the market?
(ii) What are the covariance’s among the various stocks?
(iii) What would be the risk of portfolio consisting of all the three stocks
equally?
(iv) What is the beta of the portfolio consisting of equal investment in each
stock?
(v) What is the total, systematic and unsystematic risk of the portfolio in
(iv)?
---------------------------------[Nov 2009, 8 Marks] ----------------------------------
Page 93
50. A has portfolio having following features:

Security 𝜷 Random Error 𝝈𝒆𝒊 Weight
L 1.60 7 0.25
M 1.50 11 0.30
N 1.40 3 0.25
K 1.00 9 0.20
You are required to find out the risk of the portfolio if the standard deviation
of the market index 𝜎𝑚 is 18%.
---------------------------------[May 2012, 8 Marks] --------------------------------
51. Five portfolios experienced the following results during a 7 year period
Portfolio Average Standard Correlation
Annual Deviation with the market
Return (Rp) (Sp) returns (r)
A 19.0 2.5 0.840
B 15.0 2.0 0.540
C 15.0 0.8 0.975
D 17.5 2.0 0.750
E 17.1 1.8 0.600
Market risk (Sm) - 1.2 -
Market Rate of 14.0 - -
Return (Rm)
Risk Free Rate (Rf) 9.0 - -
Rank the portfolios using (a) Sharp’s Method, (b) Treynor’s Method and (c)
Jensen’s Alpha
Page 94
52. Following are the security returns and market returns for last 10 months
Security Return Market Return (Y)
(X)
1 4.6 3.2
2 -0.5 0.3
3 3.3 3.8
4 3.9 3.5
5 -2.3 -1.6
6 4.5 4.1
7 4.6 4.0
8 4.3 4.4
9 4.1 6.0
10 -3.6 -2.7
Estimate the values of α & β for the security
53. An Investor has two portfolios known to be on minimum variance set for a
population of three securities A, B and C having below mentioned weights:
WA WB WC
Portfolio X 0.30 0.40 0.30
Portfolio Y 0.20 0.50 0.30
It is supposed that there are no restrictions on short sales.

(i) What would be the weight for each stock for a portfolio constructed by
investing `5,000 in portfolio X and `3000 in portfolio Y?
(ii) Suppose the investor invests `4,000 out of `8,000 in security A. How he
will allocate the balance between security B and C to ensure that his
portfolio is on minimum variance set?
----------------------------[Jun 2009, 6 Marks] --------------------------------------
Page 95
54. The rates of return on the security of Company X and market portfolio for
10 periods are given below:
Year Return on Security Return on Market Portfolio
1 20 22
2 22 20
3 25 18
4 21 16
5 18 20
6 -5 8
7 17 -6
8 19 5
9 -7 6
10 20 11
(i) What is the beta of Security X?

(ii) What is the characteristic line for Security X?
---------------------------------[Nov 2003, 10 Marks] ------------------------------
55. The returns on stock A and market portfolio for a period of 6 years are as
follows:
Year Return on A (%) Return on market Portfolio(%)
1 12 8
2 15 12
3 11 11
4 2 -4
5 10 9.5
6 -12 -2
You are required to determine
i. Characteristic line for stock A
ii. The systematic and unsystematic risk of stock A.
----------------------------[Jun 2009, 8 Marks] -------------------------------------
Page 96
56. Assuming that shares of ABC Ltd. and XYZ Ltd. are correctly priced
according to Capital Asset Pricing Model. The expected return from and Beta
of these shares are as follows:
Share Beta Expected Return
ABC 1.2 19.8%
XYZ 0.9 17.1%
You are required to derive Securities Market Line.
57. The expected return of the market portfolio is 14% and the risk free rate is
10%. The standard deviation of the market portfolio is 28% whereas the
standard deviation of the portfolio of an investor is 37%. Find out the expected
return of the investor as per CML
58. Expected returns on two stocks for particular market returns are given in the
following table:
Market return Aggressive Defensive
7% 4% 9%
25% 40% 18%
(a) The Betas of the two stocks.
(b) Expected return of each stock, if the market return is equally likely
to be 7% or 25%.
(c) The Security Market Line (SML), if the risk free rate is 7.5% and
market return is equally likely to be 7% or 25%.
(d) The Alphas of the two stocks.
-------------------------------[May 2007, 8 Marks]-----------------------------------
Page 97
59. Ramesh wants to invest in stock market. He has got the following
information about individual securities:
Security Expected Beta σ2 ci
Return
A 15 1.5 40
B 12 2.0 20
C 10 2.5 30
D 09 1.0 10
E 08 1.2 20
F 14 1.5 30
Market index variance is 10 percent and the risk free rate of return is 7%.
What should be the optimum portfolio assuming no short sales?
--------------------------------[May 2010, 10 Marks] -------------------------------
60. Indira has a fund of `3 lacs which she wants to invest in share market with
rebalancing target after every 10 days to start with for a period of one month
from now. The present NIFTY is 5326. The minimum NIFTY within a month
can at most be 4793.4. She wants to know as to how she should rebalance her
portfolio under the following situations, according to the theory of Constant
Proportion Portfolio Insurance Policy, using “2” as the multiplier:
(1) Immediately to start with.
(2) 10 days later being the 1st day of rebalancing if NIFTY falls to 5122.96.
(3) 10 days further from the above date if the NIFTY touches 5539.04.
For the sake of simplicity, assume that the value of her equity component will
change in tandem with that of the NIFTY and the risk free securities in which
she is going to invest will have no Beta.
--------------------------------[May 2012, 8 Marks] ----------------------------------
Page 98
61. Ms. Sunidhi is working with an MNC at Mumbai. She is well versant with the
portfolio management techniques and wants to test one of the techniques on
an equity fund she has constructed and compare the gains and losses from the
technique with those from a passive buy and hold strategy. The fund consists
of equities only and the ending NAVs of the fund he constructed for the last
10 months are given below:
Month Ending NAV Month Ending NAV
Dec 2008 40.00 May 2009 37.00
Jan 2009 25.00 Jun 2009 42.00
Feb 2009 36.00 Jul 2009 43.00
Mar 2009 32.00 Aug 2009 50.00
Apr 2009 38.00 Sep 2009 52.00
Assume Sunidhi had invested a notional amount of `2 lakhs equally in the
equity fund and a conservative portfolio (of bonds) in the beginning of
December 2008 and the total portfolio was being rebalanced each time the
NAV of the fund increased or decreased by 15%.
You are required to determine the value of the portfolio for each level of NAV
following the Constant Ratio Plan.
62. Suppose that economy A is growing rapidly and you are managing a global
equity fund and so far you have invested only in developed-country stocks
only. Now you have decided to add stocks of economy A to your portfolio.
The table below shows the expected rates of return, standard deviations, and
correlation coefficients (all estimates are for aggregate stock market of
developed countries and stock market of Economy A).
Developed Country Stocks of
Stocks Economy A
Expected rate of return 10 15
Risk 16 30
Correlation Coefficient 0.30
Page 99
Assuming the risk-free interest rate to be 3%, you are required to determine:
a) What percentage of your portfolio should you allocate to stocks of
Economy A if you want to increase the expected rate of return on your
portfolio by 0.5%?
b) What will be the standard deviation of your portfolio assuming that
stocks of Economy A are included in the portfolio as calculated above?
c) Also show how well the Fund will be compensated for the risk
undertaken due to inclusion of stocks of Economy A in the portfolio?
63. Following are the details of a portfolio consisting of three shares:

Share Portfolio Beta Expected Return Total
Weight % Variance
A 0.20 0.40 14 0.015
B 0.50 0.50 15 0.025
C 0.30 1.10 21 0.100
Standard Deviation of Market Portfolio Returns = 10%
You are given the following additional data:
Covariance (A, B) 0.030
Covariance (A, C) 0.020
Covariance (B, C) 0.040
Calculate the following:
(i) The Portfolio Beta
(ii) Residual variance of each of the three shares
(iii) Portfolio variance using Single Index Model
(iv) Portfolio variance (on the basis of modern portfolio theory given by
Markowitz)
--------------------------------[May 2019, 8 Marks]----------------------------------
Page 100
64. Mr. Abhishek is interested in investing `2,00,000 for which he is considering

following three alternatives:
(i) Invest `2,00,000 in Mutual Fund X (MFX)
(i) Invest `2,00,000 in Mutual Fund Y (MFY)
(i) Invest `1,20,000 in Mutual Fund X (MFX) and `80,000 in Mutual Fund
Y (MFY)
Average annual return earned by MFX and MFY is 15% and 14% respectively.
Risk free rate of return is 10% and market rate of return is 12%. Covariance of
returns of MFX, MFY and market portfolio Mix are as follow
Shares MFX MFY Mix

MFX 4.800 4.300 3.370
MFY 4.300 4.250 2.800
Mix 3.370 2.800 3.100
(i) variance of return from MFX, MFY and market return,
(ii) portfolio return, beta, portfolio variance and portfolio standard
deviation,
(iii) expected return, systematic risk and unsystematic risk; and
(iv) Sharpe ratio, Treynor ratio and Alpha of MFX, MFY and Portfolio Mix
65. Following information is available regarding four Mutual Funds

Mutual Fund Return R Risk 𝝈 Beta β
A 13% 16 0.90
B 17% 23 0.86
C 23% 39 1.20
D 15% 25 1.38
Evaluate performance of these mutual funds using Sharpe Ratio and Treynor’s
Ratio. Comment on the evaluation after ranking funds, given that the risk free
rate is 9%
Page 101
66. ABC Ltd. manufactures Car Air Conditioners (ACs), Window ACs and Split
ACs constituting 60%, 25% and 15% of total market value. The stand-alone
Standard Deviation (SD) and Coefficient of Correlation with market return of
Car AC and Window AC is as follows:
Standard Coefficient of
Deviation Correlation
Car AC 0.30 0.6
Window AC 0.35 0.7
No data for stand-alone SD and Coefficient of Correlation of Split AC is
available. However, a company who derives its half value from Split AC and
half from Window AC has a SD of 0.50 and Coefficient of correlation with
market return is 0.85. Market Index has a return of 10% and SD of 0.20.
Further, the risk free rate of return is 4%.
You are required to determine:
a. Beta of ABC Ltd.
b. Cost of Equity of ABC Ltd.
c. Assuming that ABC Ltd. wants to raise debt of an amount equal to
half of its Market Value then determine equity beta, if yield of debt is
5%.
67. Given below is information of market rates of Returns and Data from two
Companies A and B:
2007 2008 2009

Market 12.0 11.0 9.0
Company A 13.0 11.5 9.8
Company B 11.0 10.5 9.5
You are required to determine the beta coefficients of the Shares of Company
A and Company B
Page 102
68. Amal Ltd. has been maintaining a growth rate of 12% in dividends. The
company has paid dividend @ `3 per share. The rate of return on market
portfolio is 15% and the risk-free rate of return in the market has been observed
as10%. The beta co-efficient of the company’s share is 1.2.
You are required to calculate the expected rate of return on the company’s
shares as per CAPM model and the equilibirium price per share by dividend
growth model.
69. The following are the data on five mutual funds:

Fund Return Standard Deviation Beta
A 15 7 1.25
B 18 10 0.75
C 14 5 1.40
D 12 6 0.98
E 16 9 1.50
You are required to compute Reward to Volatility Ratio and rank these
portfolio using:
♦ Sharpe method and
♦ Treynor's method
assuming the risk free rate is 6%.
70. Assuming that two securities X and Y are correctly priced on SML and
expected return from these securities are 9.40% (Rx) and 13.40% (Ry)
respectively. The Beta of these securities are 0.80 and 1.30 respectively. Mr.
A, an investment manager states that the return on market index is 9%.
You are required to determine,
(a) Whether the claim of Mr. A is right. If not then what is correct return on
market index.
(b) Risk Free Rate of Return
--------------------------------[RTP May 2012] ----------------------------------
Page 103
71. The following details are given for X and Y companies’ stocks and the Bombay
Sensex for a period of one year. Calculate the systematic and unsystematic risk
for the companies’ stocks. What would be the portfolio risk if equal amount of
money is allocated among these stocks?
X Stock Y Stock Sensex
Average Return 0.15 0.25 0.06
Variance of Return 6.30 5.86 2.25
Beta 0.71 0.685
Correlation Coefficient (r) 0.424
Co-efficient of Determination (𝒓𝟐 ) 0.18
-----------------------------------[RTP May 2016] -------------------------------------
72. Mr Gupta is considering investment in shares of R Ltd. he has the following

expectations of returns on the stock and the market
Probability R Ltd. Market

0.35 30 25
0.30 25 20
0.15 40 30
0.20 20 10
You are required to
1. Calculate the Expected Return, Variance and Standard Deviation of

R ltd.
2. Calculate the Expected Return, Variance and Standard Deviation of
Market.
3. Find out the beta coefficient of R ltd.
--------------------------------[Nov 2018, 8 Marks] ----------------------------------
Page 104
73. Ms. Preeti, a school teacher after retirement has built up a portfolio of
Rs.120000 which is as follows
Stock No. of Market Price Beta
Shares per Share
ABC Ltd 1000 50 0.9
DEF Ltd 500 20 1.0
GHI Ltd 800 25 1.5
JKL Ltd 200 200 1.2
Her portfolio consultant Sri Vijay had advised her to bring down the beta to
0.8.
You are required to compute
(i) Present Portfolio Beta
(ii) How much risk free investment should be bought in, to reduce the
beta to 0.8
--------------------------------[May 2019, 8 Marks] ----------------------------------
74. Assume that the following one-factor model describes the expected return for
portfolios: E(Rp) = 0.10 + 0.12βp,1
Also assume that all investors agree on the expected returns and factor
sensitivity of the three highly diversified Portfolios A, B, and C given in the
following table:
Portfolio Expected Return Factor Sensitivity

A 0.20 0.80
B 0.15 1.00
C 0.24 1.20
Assuming the one-factor model is correct and based on the data provided for
Portfolios A, B, and C, determine if an arbitrage opportunity exists and explain
how it might be exploited.
Page 105
75. Consider the following asset class returns for calendar year 2016:
Asset Class Portfolio Benchmark Portfolio Benchmark

Weight (%) Weight(%) Return (%) Return (%)
Domestic Equities 55 40 10 8
International Equities 20 30 10 9
Bonds 25 30 5 6
What is the value added (or active return) for the managed portfolio?
Page 106

Portfolio Management CA Final SFM by CA Mayank Kothari PDF

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Portfolio Management CA Final SFM by CA Mayank Kothari PDF

Uploaded by

Copyright:

Available Formats

CA Final SFM | Chapter 7

For support Call 8448449881 or Mail at support@Conferenza.in

2 What are Some Types of Investments? 2

3 Are there risks associated with investing? 2

7 Distinguish between Systematic Risk and Unsystematic Risk 8

9 How to calculate beta? 10

11 Write a short note on Risk – Return Trade off 14

12 Define Portfolio and Portfolio Management 15

13 Write a short note on Objectives of Portfolio Management 16

14 Explain 5 phases of Portfolio Management 17

15 Explain how to calculate Portfolio Return 20

16 Explain how to calculate Risk of Portfolio having 2 securities/assets 20

17 Explain how to calculate Risk of Portfolio having 3 securities/assets 21

18 How to calculate the portfolio beta 22

20 Write a short note on Diversification 23

21 What are the theories in Portfolio Management 24

23 State the assumptions of Markowitz Model or Modern Portfolio Theory 25

24 What is Efficient Frontier? 26

25 Write a short note on Capital Asset Pricing Model 29

26 What are the assumptions of CAPM 32

27 What are the Advantages and Limitations of CAPM 32

28 How to find out if the stock is undervalued, overvalued or correctly Valued 33

29 Write a short note on Arbitrage Pricing Theory 34

30 Write a short note on Single Index Model 37

32 Write a short note on Sharpe’s Optimal Portfolio Theory 40

34 or Write a short note on Constant Proportion Portfolio Insurance 46

36 Make a comparative evaluation of Portfolio Rebalancing Theories 49

37 Write a short note on Short Selling 51

38 Write a short note on Market Lines 53

39 Discuss Principles and Management of Hedge Funds 55

40 Explain different types of Asset Allocation Strategies 57

41 Explain the process involved in fixed income portfolio 60

43 Discuss about the fixed income portfolio management strategy 63

44 What is Alternative Investment? 65

45 What are the features or characteristics of Alternative Investment? 66

46 What are the different types of Alternative Investments? 66

47 What makes the Real Estate Valuation complex? 67

48 What approaches are used for Real Estate Valuation? 67

49 What is Mezzanine Finance? 68

50 What is Venture Capital Fund? 68

51 What are the characteristics of venture capital fund? 69

53 Discuss the stages of funding in Venture Capital Finance 70

54 Discuss the venture capital investment process 70

55 What is a distressed security? 72

56 What types of risk has to be analyzed before investing in distressed securities? 73

57 Practical Questions 1-75 74-106

Q1. What is investing?

Q2. What are Some Types of Investments?

Q3. Are there risks associated with investing?

Q4. Explain with example how to calculate return of investment in single

0.50 + (17.50 − 12.00)

Summary Class Notes

Q5. Explain with example how to calculate risk of investment in single

- As you have calculated the squares of each deviation now multiply it

Q6. Explain the components of Total Risk. Or Write a short note on

Unsystematic Risk: Unsystematic risk is the risk specific to the company.

Q7. Distinguish between Systematic Risk and Unsystematic Risk.

Q8. What is Beta?

Q9. How to calculate beta?

Corrim σi σm 0.93 x 18.55 x 14.41

Q10. Explain the Concept of Coefficient of Correlation (r), Covariance

̅̅̅̅𝐚 = Expected or mean return on stock a

You will always talk about correlation as a range between -1 and 1.