Module-3 Assignment for EMBA-IV ,2021

Student Name: Rahul MJ

USN No: CMS19EMB197

Email ID: Rahulmj08@gmail.com

Mobile Number: 9632762919

1. What are the steps involved in the traditional approach to portfolio construction?

Ans:

The smart beta portfolio construction approach is designed to use rule-based portfolio process
through systematic selection, use of weighing techniques, and re balancing a combination of
projects with consideration to risks preferences and at times with respect to portfolio behavioural
changes.

The differences between the approach above and that of the traditional market capitalization
weighing is that ; the smart beta approach considers the probability of the availability of other
market inefficiencies that can harm an investment but the traditional market capitalization weighing
only considers the aspect of pricing as the sole risk in investments.

The top-down approach is where larger tasks are disintegrated into small tasks that can be easily
handled, but when it comes to bottom-up approach, each segment of task is solved separately
without breaking them down, then later the different tasks are combined into a single unit program.

2. Explain the constraints in the formation of objectives?

Ans:

Investment constraints are the factors that restrict or limit the investment options available to an
investor. The constraints can be either internal or external constraints. Internal constraints are
generated by the investor himself while external constraints are generated by an outside entity, like
a governmental agency.

Following are the types of investment constraints

Liquidity

Such constraints are associated with cash outflows expected and required at a specific time in future
and are generally in excess of income available. Moreover, prudent investors will want to keep aside
some money for unexpected cash requirements. The financial advisor needs to keep liquidity
constraints in mind while considering an asset’s ability to be converted into cash without impacting
the portfolio value significantly.
 Time Horizon

These constraints are related to the time periods over which returns are expected from portfolio to
meet specific needs in the future. An investor may have to pay for college education for children or
needs the money after his retirement. Such constraints are important to determine the proportion
of investments in long-term and short-term asset classes.

Tax

These constraints depend on when, how and if returns of different types are taxed. For an individual
investor, realized gains and income generated by his portfolio are taxable. The tax environment
needs to be kept in mind while drafting the policy statement. Often, capital gains and investment
income are subjected to differential tax treatments.

Legal and Regulatory

Such constraints are mostly externally generated and may affect only institutional investors. These
constraints usually specify which asset classes are not permitted for investments or dictate any
limitations on asset allocations to certain investment classes. A trust portfolio for individual investors
may have to follow substantial regulatory and legal constraints.

Unique Circumstances

Such constraints are mostly internally generated and signify investor’s special concerns. Some
individuals and philanthropic organizations may not invest in companies selling alcohol, tobacco or
even defense products. Such concerns and any special circumstance restricting the investor’s
investments should be well considered while formulating investment policy statement.

3. The need for constant income depends on the

A ) Market risk b) inflation risk c) interest risk d) unique risk

Ans: b) inflation risk

Inflation risk (purchasing power risk) occurs when the price of products and services rises faster than
expected, or when the same amount of money has less buying power. When one's monetary income
remains constant but the price level rises, that income's buying power decreases. Because real
income refers to income adjusted for inflation, a greater real income translates to more purchasing
power.

4. Define efficient frontier. Distinguish between efficient portfolio and feasible portfolio.

Ans:

 Efficient Frontier is a graph made from optimum portfolios.

  These portfolios offer the highest return for a given level of risk or
 Have the lowest level of risk given an expected return

Distinguish between the feasible set of portfolios and the efficient set of portfolios.

 A Feasible portfolio is a combination of assets that satisfies the requirements of Investors

Risk and return. In contrast, Efficient portfolios are the set of Feasible portfolios that lie on
the efficient Frontier.
 There might be a portfolio that may offer a better return than a feasible portfolio for the
same level of risk, but there cannot be one that beats an efficient portfolio.
 There might be a portfolio that may offer lower risk than a feasible portfolio for the same
level of return, but there cannot be one that beats an efficient portfolio.

5. Stocks X and Y display the following returns over the past three years:

Returns Returns
Year X Y
2012 14 12
2013 16 18
2014 20 15

a) What is the expected return on a portfolio made up of 40% of X and 60% of Y?

b) What is the standard deviation of each stock?
c) Determine the correlation coefficient of stock X and Y.
d) What is the portfolio risk of portfolio made up of 40% of X and 60% of Y?

Ans:

a) Expected rate of return = Total returns/no of years

 X = (14+16+20)/3 = 16.67
 Y = (12+18+15)/3 = 15

expected return on a portfolio made up of 40% of X and 60% of Y = (40% x 16.67) + (60% x 15)
= 6.668 + 9
= 15.67

b) Standard Deviation

2 2
Year Returns X-X’ Sigma (X-X’) Returns Y-Y’ Sigma (Y-Y’)
(X) (Y)
2012 14 -2.67 7.13 12 -3 9
2013 16 -0.66 0.43 18 3 9
2014 20 3.33 11.09 15 0 0
50 0 18.65 45 0 18
 Standard Deviation= sq rt Sigma (X-X’/n)
X = sq rt (18.65/3) = 2.49
Y = sq rt (18/3) = 2.45

c) Correlation coefficient of stock X and Y

X-X’ Y-Y’ (X-X’)(Y-Y’)

-2.67 -3 8.01
-0.66 3 -1.98
3.33 0 0
6.02

Cov = sigma (X-X’)(Y-Y”)/n

= 6.02/3 = 2.01

Cor = Cov XY/ sdX sdY

= 2.01/(2.49 x 2.45)

= 2.01/6.1 = 0.3295

d) Portfolio risk of portfolio made up of 40% of X and 60% of Y

P = sq rt [ (0.16x6.2)+(0.36x6.01)+(2x0.4x0.6x0.3295)]

= sq rt [0.992+2.1636+0.1582]

= sq rt [3.3138]

= 1.8204

6. Mr Abubakar has a portfolio comprising five stocks with the following expected market values and
returns.

Stocks Market value Return

A 20,000 10%
B 25,000 18%
C 30,000 15%
 D 1,00,000 12%
E 1,000 8%
Total 1,76,000

Determine their expected return.

Ans:

7. How many inputs are needed for a portfolio analysis involving 60 securities in the Sharpe and
Markowitz models?
Ans:

I. Sharpe:182 data inputs

II. Markowitz :1890 data inputs

Explanation:

(i). Sharpe index formula is given by:

3N + 2
Where N = number of the number of securities forming the portfolio 
In our case, the number of securities is 60.
We can therefore say, N = 60
3N +2 as per our formula will be: 
(3x60) + 2 
=182 data inputs

 
(ii). Markowitz formula is given as:

N (N +3)/2 
Where N is the number of derivative securities forming up the portfolio. 
We, therefore, give the representation as N=60
Replacing figures into the formula: 
60( 60 + 3) /2 
(3600 + 180)/2
3780/2
=1890 data inputs

8. What are the basic assumption of CAPM? What are the advantages of adopting the CAPM model in
the portfolio management?

Ans:
 CAPM method is used as a model representing the Risk of investment and expected return of an
investment in securities. The return on securities will show under the CAPM model, which is based
on risk-free interest plus a risk premium that is based on the beta.

FORMULA:

CAPM = Rf + B(Rm-Rf)
Rf = risk free interest
Rm = market return
B = Beta

Explanation

Advantages of CAPM:

Diversified Portfolio: Diversified portfolio is similar to that assumption held by the investor, similar
to a market portfolio.(exclude unsystematic risk)
Systematic Risk: Under CAPM, Systematic Risk is considered, which is a significant variable because
that is unforeseen and that the reason cannot be completely mitigated.
Business and Financial Risk: CAPM helps to calculate other business opportunities if business mix
and financial differ from current business.

The disadvantage of CAPM:

Beta = Sometimes, a business doesn't have beta information about the project. Due to that, they use
proxy beta and can't rely on that outcome.
Rm = market return is used as short-term capital gain and add dividends, but that is not for the long
term, and also there is the problem that what if current market return is harmful and that cant be
used for long term.
RF = Risk-free return is the yield on govt securities, and Rf changes daily.

9. Distinguish between the Security market line and capital market line?

Ans:

Capital market line:

 CML shows the tradeoff between expected return and total risk.
 CML considers both systematic and unsystematic risk.
 CML is the graphical presentation of the equilibrium relationship between expected return
and total risk for efficiency diversified portfolios.
 The slope of the CML shows the market price of risk for efficient portfolios.
 The CML is a line that is used to show the rates of return, which depends on risk-free rates of
return and levels of risk for a specific portfolio.
 Slope of the CML = (Rm – Rf) / σm

Security market line:

 SML shows the tradeoff between the required rate of return and systematic risk.
 SML considers only systematic risk.
  SML is the graphical presentation of CAPM.
 The slope of the SML shows the differences between the required rate of return on the
market index and the risk-free rate.
 SML is a graphical representation of the market’s risk and returns at a given time.
 The slope of the SML = (Rm – Rf).

10. The estimated rates of return, beta coefficients and standard deviation of some securities are as
given below.

Security Estimated return (%) Beta Standard Deviation (%)

A 35 1.6 50
B 28 1.4 40
C 21 1.1 30
D 18 0.9 25
E 15 0.75 20

The risk free rate of return is 8%. The market return is expected to be 20%.
Determine which of the above securities are overpriced and which are under-priced?

Ans:

Expected return (ER) = Rf + B (Rm-Rf)

Given : Rf = 8%, Rm = 20%

A = 8+1.6(20-8) = 27.2
B = 8+1.4(20-8) = 24.8
C = 8+1.1(20-8) = 21.2
D = 8+0.9(20-8) = 18.8
E = 8+0.75(20-8) = 17

Security Estimated return (%) Expected return (%) Inference

A 35 27.2 Under-priced
B 28 24.8 Under-priced
C 21 21.2 Overpriced
D 18 18.8 Overpriced
E 15 17 Overpriced