Wealth Management and

Personal Financial Planning

Faculty : Kavitha P
LM Thapar School of Management
BE MBA
Session 8-10
Topics for discussion
• Various Investment options or Asset class
• Risk and Return of Investments
• Concept of Asset allocation and Risk profiling
• Importance of Risk profiling for meeting Investment objectives
• Quantification of investment objectives
• Designing investment plans
What is an Asset class??
1. An Asset Class is a group of different financial assets or instruments
which have some similarity in terms of safety, returns and liquidity.
2. Typically various investment avenues under one asset class respond
similarly to market conditions.
3. Asset classes have shown significantly different performance in
different market conditions.-Correlation of returns
5. The process of allocating or investing some amount to different
financial assets or financial instruments is called ‘Asset Allocation’.
Classification
• Securities, currencies, and contracts are classified as financial assets
whereas commodities and real assets are classified as physical assets.
• An intangible asset is an asset that is not physical in nature. Goodwill, brand
recognition and intellectual property, such as patents, trademarks, and
copyrights, are all intangible assets.
• Securities generally include debt instruments, equities, and shares in pooled
investment vehicles. Currencies are monies issued by national monetary
authorities. Contracts are agreements to exchange securities, currencies,
commodities or other contracts in the future
• Commodities include precious metals, energy products, industrial metals,
and agricultural products.
• Real assets are tangible properties such as real estate, airplanes, or
machinery
Where to include Cryptocurrencies
• IFRIC Committee defined characteristics of an asset that, if met, would be deemed
“cryptocurrency” These characteristics are as follows:
• A digital or virtual currency recorded on a distributed ledger that uses cryptography for security
• Not issued by a jurisdictional authority or other party
• Does not give rise to a contract between the holder and another party
• Financial assets are accounted for under IFRS 9 Financial Instruments
• IAS 32 Financial Instruments: Presentation defines a financial asset.A financial asset is one that is:
• Cash
• An equity instrument of another entity
• A contractual right to receive cash or another financial asset from another entity
• A contractual right to exchange financial assets or financial liabilities with another entity under particular conditions,
or
• A particular contract that will or may be settled in the entity’s own equity instruments
• holding of cryptocurrency is not a financial asset as none of the points above are met.
Can Crypto be considered as cash??
• The IFRIC Committee looked to IAS 32 for the description of cash,
which they observed
• “implies that cash is expected to be used as a medium of exchange (i.e. used
in exchange for goods or services) and as the monetary unit in pricing goods or
services, to such an extent that it would be the basis on which all transactions
are measured and recognized in financial statements.”
• Based on this description, the Committee concluded that
cryptocurrencies are not cash.
• IAS 7 defines cash equivalents as ‘short-term, highly liquid
investments that are readily convertible to known amounts of cash and
which are subject to an insignificant risk of changes in value’.
• Thus, cryptocurrencies cannot be classified as cash equivalents
because they are subject to significant price volatility.
Crypto as intangible assets
• Cryptocurrencies are intangible assets.
• IAS 38 Intangible Assets defines an intangible asset as ‘an identifiable
non-monetary asset without physical substance.’ Two critical
characteristics of that definition are “identifiable” and
“non-monetary."
• Identifiable
• IAS 38 states that an asset is identifiable if it is separable or arises from
contractual or other legal rights.
• Non-monetary
• Guidance on what is non-monetary can be found in IAS 21 The Effects of
Changes in Foreign Exchange Rates. IAS 21 states that “the essential feature
of a non-monetary item is the absence of a right to receive (or an obligation to
deliver) a fixed or determinable number of units of currency."
Securities
• Securities are further classified as debt or equity or pooled investments
• Pooled investment vehicle shares represent ownership of an undivided
interest in an investment portfolio. The portfolio may include
securities, currencies, contracts, commodities, or real assets.
• Mutual funds, hedge funds, exchange traded funds, pension funds, and
unit investment trusts are all examples of professionally managed
pooled funds.
• Private and public securities- Publicly issues vs. private placements
Contracts
• Contracts are derivative contracts if their values depend on the prices of other
underlying assets.
• Derivative contracts may be classified as physical or financial depending on
whether the underlying instruments are physical products or financial securities.
• Equity derivatives are contracts whose values depend on equities or indexes of
equities. Fixed-income derivatives are contracts whose values depend on debt
securities or indexes of debt securities.
• Markets that trade contracts that call for delivery in the future are forward or
futures markets.
• Those that trade for immediate delivery are called spot markets to distinguish them
from forward markets that trade contracts on the same underlying instruments.
• Options markets trade contracts that deliver in the future, but delivery takes place
only if the holders of the options choose to exercise them
Another Classification of Assets
• Traditional investments include all publicly traded debts and equities
and shares in pooled investment vehicles that hold publicly traded
debts and/or equities.
• Alternative investments include hedge funds, private equities
(including venture capital), commodities, real estate securities and real
estate properties, securitized debts, operating leases, machinery,
collectibles, and precious gems
Identify the security
• The investment policy of a mutual fund only permits the fund to invest
in public equities traded in secondary markets. Would the fund be able
to purchase:
1 Common stock of a company that trades on a large stock exchange?
2 Common stock of a public company that trades only through dealers?
3 A government bond?
4 A single stock futures contract?
5 Common stock sold for the first time by a properly registered public
company?
6 Shares in a privately held bank with €10 billion of capital?
Solution
• Solution to 1:
• Yes. Common stock is equity. Those common stocks that trade on large exchanges invariably are public equities
that trade in secondary markets.
• Solution to 2:
• Yes. Dealer markets are secondary markets and the security is a public equity.
• Solution to 3:
• No. Although government bonds are public securities, they are not equities. They are debt securities.
• Solution to 4:
• No. Although the underlying instruments for single stock futures are invariably public equities, single stock
futures are derivative contracts, not equities.
• Solution to 5:
• No. The fund would not be able to buy these shares because a purchase from the issuer would be in the primary
market. The fund would have to wait until it could buy the shares from someone other than the issuer.
• Solution to 6:
• No. These shares are private equities, not public equities. The public prominence of the company does not make
its securities public securities unless they havebeen properly registered as public securities.
Pooled Investments
• Pooled investment vehicles are mutual funds, trusts, depositories, and hedge funds, that issue securities that
represent shared ownership in the assets that these entities hold.
• Mutual funds are investment vehicles that pool money from many investors for investment in a portfolio of
securities. They are often legally organized as investment trusts or as corporate investment companies.
• Pooled investment vehicles may be open-ended or closed-ended. Open-ended funds issue new shares and
redeem existing shares on demand, usually on a daily basis.
• The price at which a fund redeems and sells the fund’s shares is based on the net asset value of the fund’s
portfolio, which is the difference between the fund’s assets and liabilities, expressed on a per share basis.
Investors generally buy and sell open-ended mutual funds by trading with the mutual fund.
• In contrast, closed-end funds issue shares in primary market offerings that the fund or its investment bankers
arrange. Once issued, investors cannot sell their shares of the fund back to the fund by demanding redemption.
Instead, investors in closed-end funds must sell their shares to other investors in the secondary market.
• The secondary market prices of closed-end funds may differ—sometimes quite significantly—from their net
asset values. Closed-end funds generally trade at a discount to their net asset values. The discount reflects the
expenses of running the fund and sometimes investor concerns about the quality of the management.
• Closed-end funds may also trade at a discount or a premium to net asset value when investors believe that the
portfolio securities are overvalued or undervalued. Many financial analysts thus believe that discounts and
premiums on closed-end funds measure market sentiment
• Exchange-traded funds (ETFs) and exchange-traded notes (ETNs) are open-ended
funds that investors can trade among themselves in secondary markets.
• The prices at which ETFs trade rarely differ much from net asset values because a
class of investors, known as authorized participants (APs), has the option of
trading directly with the ETF.
• Asset-backed securities are securities whose values and income payments are
derived from a pool of assets, such as mortgage bonds, credit card debt, or car
loans.
• These securities typically pass interest and principal payments received from the
pool of assets through to their holders on a monthly basis.
• Hedge funds??
Positions
• A position in an asset is the quantity of the instrument that an entity owns or owes.
• People have long positions when they own assets or contracts.
• Examples of long positions include ownership of stocks, bonds, currencies,
contracts, commodities, or real assets. Long positions benefit from an appreciation
in the prices of the assets or contracts owned
• People have short positions when they have sold assets that they do not own, or
when they write and sell contracts.
Short Selling
• Short sellers create short positions in securities by borrowing securities from security lenders who
are long holders. The short sellers then sell the borrowed securities to other traders.
• Short sellers close their positions by repurchasing the securities and returning them to the security
lenders. If the securities drop in value, the short sellers profit because they repurchase the securities
at lower prices than the prices at which they sold the securities. If the securities rise in value, they
will lose.
• Short sellers who buy to close their positions are said to cover their positions.
• The potential gains in a long position generally are unbounded. For example, the stock prices of such
highly successful companies as Yahoo! have increased more than 50-fold since they were first
publicly traded. The potential losses on long positions, however, are limited to no more than 100
percent—a complete loss—for long positions without any associated liabilities.
• In contrast, the potential gains on a short position are limited to no more than 100 percent whereas
the potential losses are unbounded. The unbounded potential losses on short positions make short
positions very risky in volatile instruments.
• As an extreme example of this, if you had shorted 100 shares of Yahoo! in July 1996 at $20 and kept
the position open for four years, you would have lost $148,000 on your $2,000 initial short position.
During this period, Yahoo! rose 75-fold to $1,500 on a split-adjusted equivalent basis.
• But if the price goes down to ‘0’ the maximum profit will be 20$ per share ie 100%
Short Selling Mechanism
• Lenders of securities own promises made by the short sellers to return the securities. These promises
are memorialized in security lending agreements. These agreements specify that the short sellers will
pay the long sellers all dividends or interest that they otherwise would have received had they not
lent their securities. These payments are called payments-in-lieu of dividends (or of interest), and
they may have different tax treatments than actual dividends and interest. The security lending
agreements also protect the lenders in the event of a stock split.
• To secure the security loans, lenders require that the short seller leave the proceeds of the short sale
on deposit with them as collateral for the stock loan. They invest the collateral in short-term
securities, and they rebate the interest to the short sellers at rates called short rebate rates.
• The short rebate rates are determined in the market and generally are available only to institutional
short-sellers and some large retail traders. If a security is hard to borrow, the rebate rate may be
very small or even negative. Such securities are said to be “on special”.
• Most security lending agreements require various margin payments to keep the credit risk among the
parties from growing when prices change.
• Securities lenders lend their securities because the short rebate rates they pay on the collateral are
lower than the interest rates they receive from investing the collateral.
• The difference is because of the implicit loan fees that they receive from the borrowers for borrowing
the stock. The difference also compensates lenders for risks that the lenders take when investing the
collateral and for the risk that the borrowers will default if prices rise significantly.
Positions in Future/Forward Contracts
• The long side of a forward or futures contract is the side that will take
physical delivery or its cash equivalent.
• The short side of such contracts is the side that is liable for the
delivery.
• The long side of a futures contract increases in value when the value
of the underlying asset increases in value
Position in Options
• The long side of an option contract is the side that holds the right to
exercise the option.
• The short side is the side that must satisfy the obligation.
• Practitioners say that that the long side holds the option and the short
side writes the option, so the long side is the holder and the short side
is the writer.
Leveraged Position
• traders can buy securities by borrowing some of the purchase price.
• They usually borrow the money from their brokers.
• The borrowed money is called the margin loan, and they are said to buy on margin.
• The interest rate that the buyers pay for their margin loan is called the call money rate.
• The call money rate is above the government bill rate and is negotiable. Large buyers
generally obtain more favorable rates than do retail buyers.
• Trader’s equity is that portion of the security price that the buyer must supply.
• Traders who buy securities on margin are subject to minimum margin requirements.
• The initial margin requirement is the minimum fraction of the purchase price that must be
trader’s equity. This requirement may be set by the government, the exchange, or the
exchange clearinghouse
• The buyer earns greater profits when prices rise and suffers greater losses when prices fall.
The relation between risk and borrowing is called financial leverage
Financial Leverage
• The leverage ratio is the ratio of the value of the position to the value of the
equity investment in it.
• The leverage ratio indicates how many times larger a position is than the
equity that supports it
• The maximum leverage ratio associated with a position financed by the
minimum margin requirement is one divided by the minimum margin
requirement.
• If the requirement is 40 percent, then the maximum leverage ratio is 2.5 =
100% position ÷ 40% equity.
• If a stock bought on 40 percent margin rises 10 percent, the buyer will
experience a 25 percent (2.5 × 10%) return on the equity investment in her
leveraged position. But if the stock falls by 10 percent, the return on the
equity investment will be −25 percent
 Computing Total Return to a Leveraged Stock
Purchase
• A buyer buys stock on margin and holds the position for exactly one year,
during which time the stock pays a dividend. For simplicity, assume that the
interest on the loan and the dividend are both paid at the end of the year.
• Purchase price $20/share
• Sale price $15/share
• Shares purchased 1,000
• Leverage ratio 2.5
• Call money rate 5%
• Dividend $0.10/share
• Commission $0.01/share
• 1 What is the total return on this investment?
Solution
• first determine the initial equity and then determine the equity remaining after the sale.
• The total purchase price is $20,000.
• The leverage ratio of 2.5 indicates that the buyer’s equity financed 40 percent = (1 ÷ 2.5) of the
purchase price. Thus, the equity investment is $8,000 = 40% of $20,000.
• The $12,000 remainder is borrowed. The actual investment is slightly higher because the buyer
must pay a commission of $10 = $0.01/share × 1,000 shares to buy the stock. The total initial
investment is $8,010.
• Proceeds on sale $15,000
• Payoff loan –12,000
• Margin interest paid –600
• Dividends received 100
• Sales commission paid –10
• Remaining equity $2,490
• the return on the initial investment of $8,010 is (2,490 – 8,010)/8,010 = –68.9%.
Commodities Exchanges in India
• The Bulk Of Trading (99.88%) is Concentrated In The Following
National-Level Commodity Exchanges:
• 1.Multi Commodity Exchange of India (MCX), Mumbai

• 2.National Commodity and Derivatives Exchange of India (NCDEX), Mumbai

• 3.National Multi Commodity Exchange (NMCE), Ahmedabad

• 4.Indian Commodity Exchange (ICEX), New Delhi

• 5.ACE Derivatives & Commodity Exchange Limited, Mumbai

• 6.Universal Commodity Exchange Limited, Navi Mumbai.

Investment
• What you do with the savings to make them increase over time is investment.
• Definition “investment is the current commitment of dollars for a period of time in
order to derive future payments that will compensate the investor for (1) the time
the funds are committed, (2) the expected
rate of inflation during this time period, and (3) the uncertainty of the future
payments.
• Required rate of return is the rate of return that compensates investors for the time
period of the investment, the expected rate of inflation, and the uncertainty of the
future cash flows.
• A central question is how investors select investments that will give them their
required rates of return.
• measure the expected or historical rate of return on an investment and also quantify
the uncertainty (risk) of expected returns to evaluate the suitability of a particular
investment.
 MEASURES OF RETURN AND RISK
• Aim: measure both historical and expected rates of return and risk
• Step 1: the historical rate of return on an individual investment over
the time
period the investment is held (that is, its holding period).
• Step 2: the average historical rate of return for an individual
investment over a number of time periods.
• Step 3:the average rate of return for a portfolio of investments.
• Step 4:traditional measures of risk for a historical time series of
returns (that is, the variance and standard deviation).
• Step 5: estimating the expected rate of return for an investment.
Measures of Historical Rates of Return
• The period during which you own an investment is called its holding period, and the return for that period is
the holding period return (HPR).
• If you commit $200 to an investment at the beginning of the year and you get back $220 at the end of the
year, what is your return for the period?
HPR = Ending Value of Investment/ Beginning Value of Investment
=$220/$200 = 1.10
HPR in percentage terms🡪 Holding period yield
• HPY = HPR - 1

• on an annual basis🡪 Annual HPR=HPR1/n

• Annual HPY🡪HPR1/n -1 also called CAGR
• The compound annual growth rate (CAGR) is the rate of return (RoR) that would be required for an
investment to grow from its beginning balance to its ending balance, assuming the profits were reinvested at
the end of each period of the investment’s life span.
Calculating Expected Return
• Risk is the uncertainty that an investment will earn its expected rate of return.
• An investor who is evaluating a future investment alternative expects or anticipates a certain rate of return.
• The investor might say that he or she expects the investment will provide a rate of return of 10 percent, but
this is actually the investor’s most likely estimate, also referred to as a point estimate.
• the investor assigns probability values to all possible returns. These probability values range from zero, which
means no chance of the return, to one, which indicates complete certainty that the investment will provide the
specified rate of return.
Guess the security!!

E(Ri) = (1.0)(0.05) = 0.05 = 5%

Same expected return but risky??
 Measuring the Risk of Expected Rates of
Return
• we can calculate the expected rate of return and evaluate the uncertainty, or risk, of an investment
by identifying the range of possible returns from that investment and assigning each possible return
a weight based on the probability that it will occur.
• Although the graphs help us visualize the dispersion of possible returns, most investors want to
quantify this dispersion using statistical techniques. These statistical measures allow you to
compare the
• Two possible measures of risk (uncertainty) have received support in theoretical work on portfolio
theory: the variance and the standard deviation of the estimated distribution of expected returns.
Risk Measures for Historical Returns
Measuring the Risk of Expected Rates of Return
Measuring Risk: Standard Deviation
A Relative Measure of Risk
• If conditions for two or more investment alternatives are not
similar—that is, if there are major differences in the expected rates of
return—it is necessary to use a measure of relative variability to
indicate risk per unit of expected return.
• A widely used relative measure of risk is the coefficient of variation
(CV), calculated as follows:
Illustration
Find CV of the following investment choices and find out which is more risky
Valuation of Bonds
• A bond represents a contract under which a borrower promises to pay
interest and principal on specific dates to the holders of the bond.
• Par Value This is the value stated on the face of the bond. It represents
the amount the firm borrows and promises to repay at the time of
maturity.
• Coupon Rate and Interest A bond carries a specific interest rate which
is called ‘the coupon rate’. The interest payable to the bond holder is
simply: par value of the bond × coupon rate.
Valuation Model
• The value of a bond - or any asset, real or financial - is equal to the
present value of the cash flows expected from it.
• Determining the value of a bond requires:
• An estimate of expected cash flows
• An estimate of the required return
• the cash flow for a non-callable bond (a bond that cannot be
prematurely retired) comprises of an annuity of a fixed coupon interest
and the principal amount payable at maturity
• where P is the value (in rupees), n is the number of years to maturity,
C is the annual coupon payment (in rupees),
• r is the periodic required return,
• M is the maturity value, and t is the time when the payment is received
Illustration
• Consider a 10-year, 12% coupon bond with a par value of ₹ 1,000. Let us assume that the required yield on
this bond is 13%. The cash flows for this bond are as follows:
• 10 annual coupon payments of ₹ 120
• ₹ 1000 principal repayment 10 years from now
• Calculate the Value of this bond
• Excel: PV of 120 for 10 years, rate 13%; pmt (-120); nper (10);type(1)
• PV of 1000 paid after 10 years PV( 13%,10,,1000,)
• Rs.946.1
• For Semi Annual
• The annual interest payment, C, must be divided by two to obtain the semi-annual interest payment.
• The number of years to maturity must be multiplied by two to get the number of half-yearly periods.
• The discount rate has to be divided by two to get the discount rate applicable to half-yearly periods
Relationship between Coupon Rate, Required
Yield, and Price
• A basic property of a bond is that its price varies inversely with yield.
• As the required yield decreases, the present value of the cash flow increases;
hence the price increases.
• Conversely, when the required yield increases, the present value of the cash flow
decreases
Bond Yields
• The commonly employed yield measures are: current yield, yield to maturity, and
yield to call.
• Current Yield The current yield relates the annual coupon interest to
• the market price. It is expressed as:

• the current yield of a 10 year, 12 percent coupon bond with a par value of ₹ 1000
and selling for ₹ 950 is 12.63 percent. (120/950)
• does not consider the capital gain (or loss) and ignores the time value of money.
Bond Yields:YTM
• The yield to maturity (YTM) of a bond is the interest rate that makes the present value of the cash flows
receivable from owning the bond equal to the price of the bond.

• it is the interest rate (r) which satisfies the equation:

• where P is the price of the bond, C is the annual interest (in rupees), M is the maturity value (in rupees), and n
is the number of years left to maturity

•
Illustration
• Consider a ₹ 1,000 par value bond, carrying a coupon rate of 9 percent, maturing after 8 years. The bond is
currently selling for ₹ 800.
• What is the YTM on this bond? Excel formula: RATE
• By linear interpolation
Yield to Call
• Some bonds carry a call feature that entitles the issuer to call (buy
back) the bond prior to the stated maturity date in accordance with a
call schedule (which specifies a call price for each call date).
• The procedure for calculating the YTC is the same as that for the YTM

• where M* is the call price (in rupees) and n* is the number of years
until the assumed call date
Equity Valuation Models
• Dividend Discount Model: the value of an equity share is equal to the present value of
dividends expected from its ownership plus the present value of the sale price expected when the equity share
is sold. For applying the dividend discount model, we will make the following assumptions: (i) dividends are
paid annually; and (ii) the first dividend is received one year after the equity share is bought
• Single-period Valuation Model :the case where the investor expects to hold the equity share for one year. The
price of the equity share will be:

• where P0 is the current price of the equity share, D1 is the dividend expected a year hence, P1 is the price of
the share expected a year hence, and r is the rate of return required on the equity share.
Illustration
• Prestige’s equity share is expected to provide a dividend of ₹ 2.00 and
fetch a price of ₹ 18.00 a year hence. What price would it sell for now
if investors’ required rate of return is 12 percent? The current price
will be:
Dividend and Growth
Illustration
• The expected dividend per share on the equity share of Roadking
Limited is ₹ 2.00. The dividend per share of Roadking Limited has
grown over the past five years at the rate of 5 percent per year. This
growth rate will continue in future. Further, the market price of the
equity share of Roadking Limited, too, is expected to grow at the same
rate. What is a fair estimate of the intrinsic value of the equity share of
Roadking Limited if the required rate is 15 percent?
Rate of Return
• What rate of return can the investor expect, given the current market
price and forecast values of dividend and share price?

• The expected dividend per share of Vaibhav Limited is ₹ 5.00.The

dividend is expected to grow at the rate of 6 percent per year. If the
price per share now is ₹ 50.00, what is the expected rate of return?
DETERMINANTS OF REQUIRED RATES OF
RETURN
• Required rate of return compensates you for: (1) the time value of
money during the period of investment, (2) the expected rate of
inflation during the period and (3) the risk involved
• Nominal Risk free return : takes into account the preference for
consumption over savings ; long term economic growth
• Real Risk free return: NRFR + inflation and capital market changes
like change in fiscal policy
• The above are common for all securities
• Expected return: Real return + uncertainty or risk
• Factors: Fundamental( Business , financial, Liquidity, Market(
Exchange, Country)
Relationship between Risk and Return
• The line that reflects the combination of risk and return available on
alternative investments is referred to as the security market line
(SML).
• The SML reflects the risk-return combinations available for all risky
assets in the capital market at a given time.
Changes in Security Market Line
• First, individual investments can change positions on the SML because
of changes in the perceived risk of the investments.
• Second, the slope of the SML can change because of a change in the
attitudes of investors toward risk; that is, investors can change the
returns they require per unit of risk.
• Third, the SML can experience a parallel shift due to a change in the
RFR (the expected rate of inflation; Consumption preference; Capital
market adjustments etc)
Risk Premium
• The slope of the SML indicates the return per unit of risk required by
all investors.
• RPi = E(Ri) − RFR
• where:
• RPi = risk premium for asset i
• E(Ri) = the expected return for asset i
• RFR = return on a risk-free asset
Market Risk Premium
• If a point on the SML is identified as the portfolio that contains all the
risky assets in the market (referred to as the market portfolio), it is
possible to compute a market RP as follows:
• RPm = E(Rm) − RFR
• where:
• RPm = the risk premium on the market portfolio
• E(Rm) = the expected return on the market portfolio
• RFR = return on a risk-free asset
Market Efficiency
• a. describe market efficiency and related concepts
• b. distinguish between market value and intrinsic value;
• c. explain factors that affect a market’s efficiency;
• d. contrast weak-form, semi-strong-form, and strong-form market
efficiency;
• e. explain the implications of each form of market efficiency for
fundamental analysis, technical analysis, and the choice between
active and passive portfolio management;
• f. describe market anomalies;
• g. describe behavioral finance and its potential relevance to
understanding market anomalies.
What is an efficient Market?
• Market efficiency concerns the extent to which market prices
incorporate available information.
• An informationally efficient market (an efficient market) is a market in
which asset prices reflect new information quickly and rationally.
An efficient market is thus a market in which asset prices reflect all
past and present information.
• Possibilities: If market prices do not fully incorporate information,
then opportunities may exist to make a profit from the gathering and
processing of information
• Why we need efficient markets: If the prices do not efficiently
incorporate information about a company’s prospects, then it is
possible that funds will be misdirected.
Returns in efficient markets
• superior, risk-adjusted returns (net of all expenses) are not achievable
in an efficient market.
• In an efficient market a passive investment strategy (i.e., buying and
holding a broad market portfolio) that does not seek superior
risk-adjusted returns can be preferred to an active investment strategy
because of lower costs (for example, transaction and
information-seeking costs).
• in an efficient market, prices should be expected to react only to the
elements of information releases that are not anticipated fully by
investors—that is, to the “unexpected” or “surprise” element of such
releases
Market value and Intrinsic Value
• Market value is the price at which an asset can currently be bought or
sold.
• Intrinsic value (sometimes called fundamental value) is, broadly
speaking, the value that would be placed on it by investors if they had
a complete understanding of the asset’s investment characteristics.
• intrinsic value can be estimated but is not known for certain
• If investors believe a market is highly efficient, they will usually
accept market prices as accurately reflecting intrinsic values.
• Discrepancies between market price and intrinsic value are the basis
for profitable active investment
Test your Understanding
Suppose that the future cash flows of an asset are accurately estimated.
The asset trades in a market that you believe is efficient based on most
evidence, but your estimate of the asset’s intrinsic value exceeds the
asset’s market value by a moderate amount. The most likely conclusion
is that you have:
• A overestimated the asset’s risk.
• B underestimated the asset’s risk.
• C identified a market inefficiency.
Determinants of ME

• Transaction cost and

arbitrage
• Information acquisition
and Active investor’s
abnormal return
Forms of ME
• Eugene Fama (1970) developed a framework for describing the degree
to which markets are efficient.
Market Pricing Anomalies
Time series Anomalies
• Calendar Anomalies & Momentum and Overreaction Anomalies
• Calendar Anomalies
Behavioral Finance and Anomalies
• Loss aversion refers to the tendency of people to dislike losses more
than they like comparable gains.
• Herding occurs when investors trade on the same side of the market in
the same securities, or when investors ignore their own private
information and/or analysis and act as other investors do
• Overconfident investors overestimate their ability to process and
interpret information about a security.
• An information cascade is the transmission of information from those
participants who act first and whose decisions influence the decisions
of others.
Portfolio Management
• Much of the risk of a single security can be eliminated by
diversification. So rational investors hold diversified portfolios.
• While diversification eliminates unsystematic risk (unique risk) it
cannot eliminate systematic risk (market risk).
• The market risk of a stock is measured by its beta. According to the
capital asset pricing model (CAPM), the expected return of a stock is
linearly related to its beta.
Portfolio Return and Risk
• the expected return on a portfolio is the weighted average of the expected returns
on the individual securities in the portfolio

• portfolio risk (measured by variance or standard deviation of returns) is not the

weighted average of the risks of the individual securities in the portfolio (except
when the returns from the securities are uncorrelated)
• Why? investors can achieve the benefit of risk reduction through diversification.
• To develop the equation for calculating portfolio risk we need information on
weighted individual security risks and weighted co-movements between the
returns on securities included in the portfolio.
• Co-movements between the returns on securities are measured by covariance (an
absolute measure) and coefficient of correlation (a relative measure)
Portfolio Return Example
Covariance
• Covariance reflects the degree to which the returns on the two securities vary or change together.
• A positive covariance means that the returns on the two securities move in the same direction whereas a
negative covariance implies that the returns on the two securities move in opposite direction.
• The covariance between the returns on any two securities i and j is calculated as follows:

• where p1, p2 … pn are the probabilities associated with states 1, … n, Ri1, … Rin are the returns on security i
in states 1, … n, Rj1, … Rjn are the returns on security j in states 1, … n, and E(Ri) and E(Rj) are the
expectedreturns on securities i and j.
Covariance Example
• The covariance between the returns on securities 1 and 2
Coefficient of Correlation
• Covariance and correlation are conceptually analogous in the sense
that both of them reflect the degree of comovement between two
variables.

where Cor (Ri, Rj) = ρij is the correlation coefficient between the
returns onsecurities i and j, Cov (Ri, Rj) = σij is the covariance between
the returns on securities i and j, and σ(Ri),σ(Rj) = σi, σj are the standard
deviations of the returns on securities i and j
Portfolio Risk Calculation
• The risk of a portfolio consisting of two securities is given by the
following formula

• where σp2 is the variance of the portfolio return, w1,w2 are the weights
of securities 1 and 2 in the portfolio, σ12,σ22 are the variances of the
returns on securities 1 and 2, and ρ12 σ1σ2 is the covariance of the
returns on securities 1 and 2.
Example
• A portfolio consists of two securities, 1 and 2, in the proportions 0.6
and 0.4. The standard deviations of the returns on securities 1 and 2
are σ1 = 10 percent and σ2 = 16 percent. The coefficient of correlation
between the returns on securities 1 and 2 is 0.5. What is the standard
deviation of the portfolio return (Risk)?
Risk Profiling
Questionnaire
• 1. You win $300 in an office football pool. You: (a) spend it on groceries, (b) purchase lottery tickets, (c) put it
in a money market account, (d) buy some stock.

• 2. Two weeks after buying 100 shares of a $20 stock, the price jumps to over $30. You decide to: (a) buy more
stock; it’s obviously a winner, (b) sell it and take your profits, (c) sell half to recoup some costs and hold the
rest, (d) sit tight and wait for it to advance even more.

• 3. On days when the stock market jumps way up, you: (a) wish you had invested more, (b) call your financial
advisor and ask for recommendations, (c) feel glad you’re not in the market because it fluctuates too much,
(d) pay little attention.

• 4. You’re planning a vacation trip and can either lock in a fixed room-and-meals rate of $150 per day or book
standby and pay anywhere from $100 to $300 per day. You: (a) take the fixed-rate deal, (b) talk to people who
have been there about the availability of last-minute accommodations, (c)book standby and also arrange
vacation insurance because you’re leery of the tour operator, (d) take your chances with standby.
• 5. The owner of your apartment building is converting the units to condominiums (Apartments). You can buy
your unit for $75,000 or an option on a unit for $15,000. (Units have recently sold for close to $100,000, and
prices seem to be going up.) For financing, you’ll have to borrow the down payment and pay mortgage and
condo fees higher than your present rent.
You: (a) buy your unit, (b) buy your unit and look for another to buy, (c) sell the option and arrange to rent the
unit yourself, (d) sell the option and move out because you think the conversion will attract couples with small
children
• 6. You have been working three years for a rapidly growing company. As an executive, you are offered the
option of buying up to 2% of company stock: 2,000 shares at $10 a share. Although the company is privately
owned (its stock does not trade on the open market), its majority owner has made handsome profits selling
three other businesses and intends to sell this one eventually.
You: (a) purchase all the shares you can and tell the owner you would invest more if allowed, (b) purchase all
the shares, (c) purchase half the shares, (d) purchase a small amount of shares.
• 7. You go to a casino for the first time. You choose to play: (a) quarter slot machines, (b) $5 minimum bet
roulette, (c) dollar slot machines, (d) $25 minimum-bet blackjack.
• 8. You want to take someone out for a special dinner in a city that’s new to you. How do
you pick a place? (a) read restaurant reviews in the local newspaper, (b) ask coworkers if
they know of a suitable place, (c) call the only other person you know in this city, who
eats out a lot but only recently moved there, (d) visit the city sometime before your dinner
to check out the restaurants yourself.
• 9. The expression that best describes your lifestyle is:(a) no guts, no glory, (b) just do it!
(c) look before you leap, (d) all good things come to those who wait.
• 10. Your attitude toward money is best described as:(a)a dollar saved is a dollar earned,
(b) you’ve got to spend money to make money, (c) cash and carry only, (d) whenever
possible, use other people’s money.
Scoring
Portfolio management Process
Policy Statement
• The policy statement is a road map; in it, investors specify the types of
risks they are willing to take and their investment goals and
constraints.
• purpose of writing a policy statement is
• to help investors understand their own needs, objectives, and investment
constraints. How? Making the statement necessitates the investor to learn
about the markets, assets classes and investing risk
• policy statement provides that objective standard. The portfolio’s performance
should be compared to guidelines specified in the policy statement, not on the
portfolio’s overall return
Contents of a Policy Statement
• Investment Objectives: The investor’s objectives are his or her
investment goals expressed in terms of both risk and
returns. The relationship between risk and returns requires that goals
not be expressed only in terms of returns. Expressing goals only in
terms of returns can lead to inappropriate investment practices by the
portfolio manager
• Investment Constraints: Liquidity, Tax Concern and Time Horizon,
Unique needs and preferences
Typically includes..
• Asset classes deemed suitable for the portfolio
• Asset allocation targets for the approved asset classes
• Personal factors and attitudes affecting the investor’s portfolio and his
or her time horizons
• Risk-return considerations for the investor and desired overall after-tax
rate of return desired; this may include an estimate of how much of a
portfolio decline (e.g., during a “bear market”) the investor feels he or
she can tolerate
• Diversification standards to be followed
• Cash flow requirements from the portfolio
• Portfolio liquidity and marketability requirements
Asset Allocation
• Asset allocation is a system for determining what percentages of an
investment portfolio should be in different asset classes and
subclasses.
• The system is based on the expected after-tax total returns on various
asset classes and their correlations, the investor’s financial situation,
the time horizon involved, personal factors and investment constraints,
the person’s investment objectives and policies, and the person’s
ability to tolerate risk (volatility of returns)
Steps in Asset Allocation
• Develop an investment policy statement.
• 2. Consider the investor’s personal situation, including investment constraints, time horizon, financial position,
tax status, and liquidity and marketability needs.
• 3. Consider the person’s investment objectives and strategies.
• 4. Review the investor’s present asset allocation.
• 5. Consider and select the asset classes deemed suitable for the particular investor’s allocation.
• 6. Estimate, to the extent possible, the long-term return-risk features of the asset classes selected. Logically, this
step might be done concurrently with the preceding one since long-term return-risk characteristics are important
in deciding which asset classes to include in a portfolio.
• 7. Consider the current and expected economic climate.
• 8. Decide on the percentage allocations of the selected asset classes in the portfolio. This, of course, is the critical
step.
• 9. Decide on suballocations within each asset class selected.
• 10. Consider, to the extent possible, how the various asset classes should be held (i.e., directly owned, through
financial intermediaries, or in tax advantaged accounts or plans).
• 11. Implement the plan.
• 12. Periodically review and reevaluate the plan