UNIT-IV

After learning this chapter, the student should be able to

 Understand the importance of portfolio analysis.

 Know the principles of Markowitz, Sharpe and Capital Asset Pricing model.
 Work out problems from the above models.

Portfolio Construction

Portfolio is a combination of securities such as stocks, bonds and money market

instruments. The process of blending together the broad asset classes so as to obtain optimum
return with minimum risk is called portfolio construction. Diversification of investments helps to
spread risk over many assets. A diversification of securities gives the assurance of obtaining the
anticipated return on the portfolio. In a diversified portfolio, some securities may not perform as
expected, but others may exceed the expectation and making the actual return of the portfolio
reasonably close to the anticipated one.
Approaches in Portfolio Construction

Commonly, there are two approaches in the construction of the portfolio of securities viz.
traditional approach and Markowitz efficient frontier. In the traditional approach, investor’s
needs in terms of income and capital appreciation are evaluated and appropriate securities are
selected to meet the needs of the investor. The common practice in the traditional approach is to
evaluate the entire financial plan of the individual. In the modern approach, portfolios are
constructed to maximize the expected return for a given level of risk. It views portfolio
construction in terms of the expected return and the risk associated with obtaining the expected
return.
Traditional Approach
The traditional approach basically deals with two major decisions. They are
i) Determining the objectives of the portfolio.
ii) Selection of securities to be included in the portfolio.
Normally, this is carried out in four to six steps. Before formulating the objectives,
the constraints of the investor should be analyzed. Within the given framework of constraints,
objectives are formulated. Then based on the objectives, securities are selected. After that, the
risk and return of the securities should be studied. The investor has to assess the major risk

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categories that he or she is trying to minimize. Compromise on risk and non-risk factors has to be
carried out. Finally relative portfolio weights are assigned to securities like bonds, stocks and
debentures and then diversification is carried out. The following flowchart explains this
STEPS IN TRADITIONAL APPROACH
Analysis of Constraints

Determination of Objectives

Selection of Portfolio

Bond and Common Bond Common Stock

Stock

Assessment of Risk and Return

Diversification

I. Analysis of Constraints
The constraints normally discussed are: Income needs, Liquidity, Time-horizon,
Safety, Tax considerations and the Temperament.
a. Income Needs
The income needs depend on the need for income in constant rupees and current
rupees. The need for income in current rupees arises from the investor’s need to meet
all or part of the living expenses. At the same time inflation may erode the purchasing
power, the investor may like to offset the effect of the inflation and so needs income at
constant rupees.

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 b. Liquidity
If the investor prefers to have high liquidity, then funds should be invested in high
quality short term debt maturity issues such as money market funds, commercial papers
and shares that are widely traded. Keeping the funds in shares that are poorly traded or
stocks in closely held business and real estate lacks liquidity.
c. Safety of the Principal
Investing in bonds and debentures is safer than investing in the stocks. Even
among the stocks, the money should be invested in regularly traded companies of
longstanding. Investing money in the unregistered finance companies may not provide
adequate safety.
d. Time Horizon
Time-horizon is the investment-planning period of the individuals. This varies
from individual to individual. Individual’s risk and return preferences are often
described in terms of his/her life cycle. The stages of human life cycle determine the
nature of investment.
e. Tax Consideration
Investors in the income tax paying group consider the tax concessions they could
get from their investments. For all practical purpose, they would like to reduce the
taxes. If the Investor cannot avoid taxes, he can delay the taxes. Investing in
government bonds and NSC can avoid taxation. This constraint makes the investor to
include the items which will reduce the tax.
f. Temperament
The temperament of the investor himself poses a constraint on framing his
investment objectives. Some investors are risk takers who would like to take up higher
risk even for low return. While some investors are risk averse, who may not be willing
to undertake higher level of risk even for higher level of return. The risk neutral
investors match the return and the risk.
II. Determination of Objectives
Portfolios have the common objective of financing present and future
expenditures from a large pool of assets. The return that the investor requires and the
degree of risk he is willing to take depend upon the constraints. The objectives of

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 portfolio range from income to capital appreciation. The common objectives are stated
below.
a. Current income
b. Growth in income.
c. Capital Appreciation.
d. Preservation of capital.
The investor in general would like to achieve all the four objectives, no
investors would like to lose his investment. But, it is not possible to achieve all the four
objectives simultaneously. If the investor aims at capital appreciation, he should include
risky securities where there is an equal likelihood of losing the capital. Thus, there is a
conflict among the objectives.
III.Selection of Portfolio
The selection of portfolio depends on the various objectives of the investor. The
selection of portfolio under different objectives are dealt subsequently.
a. Objectives and asset mix
If the main objective is getting amount of current income, 60% of
the investment is made on debts and 40% on equities. The proportions of
investments on debt and equity differ according to the individual’s
preferences.
b. Growth of income and asset mix
Here the investor requires a certain percentage of growth in the
income received from his investment. The investor’s portfolio may consist of
60 to 100 percent equities and 0 to 40 percent debt instruments.
c. Capital appreciation and asset mix
Capital appreciation means that the value of the original
investment increases over the years. Investment in real estate like land and
house may provide a faster rate of capital appreciation but they lack liquidity.
In the capital market, the values of the shares are much higher than their
original price.
d. Safety of the Principal and asset mix

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 Usually, the risk averse investors are very particular about the
stability of principal. According to the life cycle theory, people in the third
stage of life also give more importance to the safety of the principal. All th
investors have this objective in their mind. No investor likes to lose his money
invested in different assets. But, the degree may differ.
IV.Risk and Return Analysis
The traditional approach to portfolio building has some basic assumptions. First,
the individual prefers larger to smaller returns from securities. To achieve this goal, the
investor has to take more risk. The ability to achieve higher returns is dependent upon his
ability to judge risk and his ability to take specific risks. The risks are namely interest rate
risk, purchasing power risk, financial risk and market risk. The investor analyses the
various degrees of risk and constructs his portfolio.
V. Diversification
Financial risk can be minimized by commitments to top-quality bonds, but these
securities offer poor resistance to inflation. Stocks provide better inflation protection than
bonds but are more vulnerable to financial risks. Good quality convertibles may balance
the financial risk and purchasing power risk. According to the investor’s need for income
and risk tolerance level portfolio is diversified. In the bond portfolio, the investor need to
strike a balance between the short term and long term bonds. Short term fixed income
securities offer more risk to income and long term fixed income securities offer more risk
to principal.
Modern Approach
The traditional approach is a comprehensive financial plan for the individual. It takes into
account the individual needs such as housing, life insurance and pension plans. But these types
of financial planning approaches are not done in the Markowitz approach. Markowitz gives
more attention to the process of selecting the portfolio. His planning can be applied more in the
selection of common stocks portfolio than the bond portfolio. The stocks are not selected on the
basis of need for income or appreciation. But the selection is based on the risk and return
analysis. Return includes the market return and dividend. The investor needs return and it may
be either in the form of market return or dividend. They are assumed to be indifferent towards
the form of return.

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 From the list of stocks quoted at the Bombay Stock Exchange or at any other
regional stock exchange, the investor selects roughly some group of shares say 10 or 15 stocks.
For these stocks expected return and risk would be calculated. The investor is assumed to have
the objective of maximizing the expected return and minimize the risk. Further, it is assumed
that investors would take up risk in a situation when adequately rewarded for it. This implies
that individuals would prefer the portfolio of highest expected return for a given level of risk.
In the modern approach, the final step is asset allocation process that is to choose
the portfolio that meets the requirement of the investor. The risk taker i.e who are willing to
accept a higher profitability of risk for getting the expected return would choose high risk
portfolio. Investor with lower tolerance for risk would choose low level risk portfolio. The risk
neutral investor would choose the medium level risk portfolio.
PORTFOLIO- MARKOWITZ MODEL
Harry Markowitz opened new vistas to modern new vistas to modern portfolio
selection by publishing an article in the Journal of Finance in March 1952. His publication
indicated the importance of correlation among the different stocks returns in the construction of
a stock portfolio. Markowitz also showed that for a given level of expected return in a group of
securities, one security dominates the other. To find out this, the knowledge of the correlation
coefficients between all possible securities combinations is required.
After the publication of his paper, numerous investment firms and portfolio
managers developed “Markowitz Algorithm” to minimize portfolio variance i.e risk. Even
today the term Markowitz diversification is used to refer to the portfolio construction
accomplished with the help of security co variances.
Simple Diversification
Portfolio risk can be reduced by the simplest kind of diversification. Portfolio
means the group of assets an investor owns. The assets may vary from stocks to different types
of bonds. Sometimes the portfolio may consist of securities of different industries. When
different assets are added to the portfolio, the total risk tends to decrease. In the case of
common stocks, diversification reduces the unsystematic risk or unique risk. Analysts opine
that if 15 stocks are added in a portfolio of the investor, the unsystematic risk can be reduced to
zero. But at the same time if the number exceed 15, additional risk reduction cannot be gained.
But diversification cannot reduce systematic or undiversifiable risk.

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 The naïve kind of diversification is known as simple diversification. In the case of sample
diversification, securities are selected at random and no analytical procedure is used.
Total risk of the portfolio consists of systematic and unsystematic risk and this total risk
is measured by the variance of the rates of returns over time.
THE MARKOWITZ MODEL
Most people agree that holding two stocks is less risky than holding one stock. For
example, holding stocks from textile, banking, and electronic companies is better than investing
all the money on the textile company’s stock. But building up the optimal portfolio is very
difficult. Markowitz provides an answer to it with the help of risk and return relationship.
Assumptions
The individual investor estimates risk on the basis of variability of returns i.e. the
variance of returns. Investor’s decision is solely based on the expected return and variance of
returns only.
For a given level of risk, investor prefers higher return to lower return. Likewise, for a
given level of return investor prefers lower risk than higher risk.
The Concept
In developing his model, Markowitz had given up the single stock portfolio and
introduced diversification. The single security portfolio would be preferable if the investor is
perfectly certain that his expectation of highest return would turn out to be real. In the world of
uncertainty, most of the risk averse investors would like to join Markowitz rather than keeping
a single stock, because diversification reduces the risk.
MARKOWITZ EFFICIENT FRONTIER

The risk and return of all portfolio plotted in risk-return space would be dominated by
efficient portfolios. Portfolio may be constructed from available securities. All the possible
combination of expected return and risk compose the attainable set.

Utility Analysis Utility is the satisfaction the investor enjoys from the portfolio return. An
ordinary investor is assumed to receive greater utility from higher return and vice-versa. The
investor gets more satisfaction or more utility in X + 1 rupees than from X rupee. If he is allowed
to choose between two certain investments, he would always like to take the one with larger
outcome. Thus, utility increases with increase in return.

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The utility function makes certain assumptions about an investors taste for risk. The investors are
categorized into risk averse, risk neutral and risk seeking investor. All the three types can be
explained with the help of a fair gamble.
In a fair gamble which cost Rs1, the outcomes are A and B events. A event will yield Rs 2.
Occurrence of B event is a dead loss i.e.0. The chance of occurrence of both the events are 50%
and 50%. The expected value of investment is (1/2)2+1/2(0)=Re1. The expected value of the
gamble is exactly equal to cost. Hence, it is a fair gamble. The position of the investor may be
improved or hurt by undertaking the gamble.
Risk avertor rejects a fair gamble because the disutility of the loss is greater for him than the
utility of an equivalent gain. Risk neutral investor means that he is indifferent to whether a fair
gamble is undertaken or not. The risk seeking investor would select a fair gamble i.e. he would
choose to invest. The expected utility of investment is higher than the expected utility of not
investing.
Markowitz Model- Problems
1. Stocks L and M have yielded the following returns for the past two years.

Years Return %
L M

1995 12 14
1996 18 12
a) What is the expected return on portfolio made up of 60 per cent of L and 40 per
cent of M?
b) Find out the standard deviation of each stock.
c) What is the covariance and co-efficient of correlation between stock L and M?
d) What is the portfolio risk of a portfolio made up of 60 per cent of L and 40 per
cent of M?

Solution

a. Expected rate of return

= ΣR
n
ΣR is the total of return n-number of observations
Returns of stock L= 12 + 28 =15
2
Stock M= 14 + 12 =13

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 2
Portfolio return =Σᴺi=ı Xı Rı
Xı being the proportion held by each security which includes 60% of L and 40% of M
=(0.6 + 15) + (0.4 x 13)
= 9 + 5.2 =14.2
b. Standard deviation of each stock
σ=√ Σ( Rı−R ı) ²
N

√ √
2
9+9
= ( 12−15 ) +( 18−15)² =
2 2

σ˪= 3

√
2
σm = Σ ( Rm−R m )
2

√
2 2
= ( 14−13 ) + ( 12−13 ) =√ 2/2 =√ 1
2
σm = 1

c. The co-variance between stock L and M

Cov ʟм = Σ(Rı-R̅ı) (Rᴍ-R̅ᴍ)
N
=(-3) + (-3)
2
= -6 = -3
2
Correlation co-efficient is
r = Covariance LM
σʟ σm

= -3 = -1

3x1

d. Portfolio risk σᴩ =√ ( Xı )2 ( σı )2 +( X ₂)²+2 Xı X ₂(rı₂ σıσ ₂¿) ¿

σᴩ =√ σᴩ ²
σᴩ =√ ( .6 )2 x 9+ ( 0.4 )2 x 1+ 2 x .6 x .4 x (3 x 1 x−1)
=3.24 +0.16 +(-1.44)
=√ σ ² ᴩ =√ 1.96 =1.4

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2. Stocks Y and Z have the following parameters

Stock Y Stock Z
Expected return 20 30
Expected variance 16 25
Covariance YZ 20

Is there any advantage of holding a combination of Y and Z

Solution

There is no advantage of holding a combination Y and Z, as risk cannot be reduced

because they are perfectly correlated.
r = Covariance yz
σy σz
σy =√ Variance y =√ 16 = 4
σz=√ Variance z =√ 25 = 5
r = 20 = +1
4x5
3. The expected rates of return and the possibilities of their occurrence for Alpha company
Beta company scrips are given below

Probability of Return on Alpha’s Return on Beta’s

Occurrence Scrip Scrip
0.05 - 2.0 -3.0
0.20 9.0 6.0
0.50 12.0 11.0
0.20 15.0 14.0
0.05 26.0 19.0
a. Find out the expected rates of return for Alpha and Beta scrips.
b. If an investor invests equal proportion on both the scrips what would be the return?
c. If the proportion is changed to 25% and 75% and then to 75% and 25% what would
be the expected rates of return?

Solution

R̅ = Σᴺi=ı Rı Pı

Return on Alpha’s scrip = Rı (Pı) + R ₂( P₂) + Rз (Pз) +R4 (P 4 )+R 5 (P5)

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 = -2.0(.05)+9.0(.20)+12(0.50)+15(.2)+26(.05)
=12%
Return on Beta’s scrip = -3.0(.05) + 6(.2) + 11(.5) +14(.2) +19(.05)
= 10.3%
b. If an investor invests equal proportion of 50%, then

Rp = Σᴺi=ı Pı Rı

Rp = .5 x 12 + .5 x 10.3

Rp = 6 + 5.15 =11.15

c.75% of Alpha security and 25% of Beta security

Rp = .75 x 12 + .25 x 10.3

= 9 + 2.575 = 11.575

25% of Alpha security and 75% of Beta security

Rp = .25 x 12 + .75 x 10.3

= 3 + 7.725 = 10.72

Portfolio Analysis-Problems

4. The return of two assets under four possible states of nature are given below:
State of Probability Return on Asset 1 % Return on Asset 2 %
Nature
1 0.10 5 0
2 0.30 10 8
3 0.50 15 18
4 0.10 20 26

a. What is the standard deviation of the return on Asset 1? Asset 2?

b. What is the covariance between the return on Asset 1? Asset 2?
c. What is the co efficient of correlation between the returns on Asset 1? Asset 2?
Solution:
a. The Expected return on asset 1 and 2 are:

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 E(R 1) = 0.1 (5%) + 0.3 (10%) + 0.5 (15%) + 0.1 (20%) =13%

E (R 2)= 0.1(0%) +0.3(8%) +0.5 (18%) +0.1(26%) =14%

The Standard deviation of the returns on assets 1 and 2 are:
σ1= [0.1(5-13)2 +0.3(10-13)2+0.5(15-13)2+0.1(20-13)2]1/2 =4%
σ2= [0.1(0-14)2+0.3(8-14)2+0.5(18-14)2+0.1(26-14)2]1/2
=[19.6+10.8+8+14.4]1/2=7.27%
b. The covariance between the returns on assets 1 and 2 is calculated below:
State Probability Return Deviation of Return Deviation of Product of
of on asset the return on on asset the return on deviation times
nature 1 asset 1 from its 2 asset 2 from its probability
mean mean
1 0.10 5% -8% 0% -14% 11.2
2 0.30 10% -3% 8% -6% 5.4
3 0.50 15% 2% 18% 4% 4
4 0.10 20% 7% 26% 12% 8.4
Sum=29.0

Thus the covariance between the returns of the two assets is 29.0
c. The coefficient of correlation between the returns on assets 1 and 2 is:
Covariance12 = 29 =0.997
σ1xσ2 4 x 7.27

5. A portfolio consists of 3 securities, 1, 2 and 3. The proportions of these securities are:

w1=0.3, w2 = 0.5, and w3=0.2. The standard deviations of return on these securities (in
percentage terms) are: σ1=6, σ2= 9 and σ3=10. The correlation coefficients among security
returns are p12=0.4, p13=0.6, p23=0.7. What is the standard deviation of portfolio return?
Solution:
σ p = [ώ2 1σ21 + ώ2 2 σ22 + ώ2 3σ23 + 2 ώ1 ώ2 ρ12 σ1 σ2 + 2 ώ1 ώ3ρ13 σ1 σ3 + 2 ώ2 ώ3 ρ23σ2 σ3]
½

[0.32x62+0.52x92+0.22x102+2x 0.3x 0.5x 0.4x6x9+2x0.3x0.2x0.6x6.10+2x0.5x0.2x0.7x9x10] 1/2

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= [3.24+22.75+4+6.48+4.32+12.6]1/2
=7.31%

6. Consider the two stocks P and Q

Stoc Expected Return (%) Standard Deviation (%)
k
P 16% 25%
Q 18% 30%

The returns on the two stocks are perfectly negatively correlated.

What is the expected return of a portfolio constructed to drive the standard deviation of portfolio
return to zero?
Solution:
The weights that drive the standard deviation of portfolio to zero, when the returns are perfectly
negatively correlated are
Wp = σQ/ σP + σQ = 30/25+30 = 0.545.
The expected return of the portfolio is
0.545 x 16% + 0.455 x 18% = 16.91%

7. The following information is available

Stock A Stock B
Expected Return 16% 12%
Standard Deviation 5% 8%
Co-efficient of 0.60
Correlation
i) What is the co-variance between Stocks A and B?
ii) What is the expected return and risk of a portfolio in which A and B have weights of 0.6
and 0.4.
Solution
i) Co-Variance (A,B) = ρAB X σA X σB
= 0.60 X 15 X 8= 72.

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 ii) Expected return = 0.6 X 16 + 0.4X12 = 14.4%
iii) Risk (Standard Deviation) =[0.62 X 225 + 0.42 X 64 + 2 X 0.6 X 0.4 X 72]1/2
= 11.22%

THE SHARPE INDEX MODEL

The investor always likes to purchase a combination of stocks that provides the
highest return and has lowest risk. The investor wishes to maintain a satisfactory reward to risk
ratio. Traditionally, analysts paid more attention to the return aspect of the stocks. These days
risk has received increased attention and analysts are providing estimates of risk as well as
return.
The Markowitz model is adequate and conceptually sound in analyzing the risk and
return of the portfolio. The problem with Markowitz model is that a number of co-variances have
to be estimated. If a financial institution buys 150 stocks, it has to estimate 11,175 i.e ( N 2-N)/2
correlation co-efficients. Sharpe has developed a simplified model to analyse the portfolio. He
assumed that the return of a security is linearly related to a single index like the market index.
The market index should consist of all the securities trading on the exchange. In the absence of
it, a popular index can be treated as a surrogate for the market index. For example, even though
BSE Sensex, BSE-100 and NSE-50 do not use all the scrips prices to construct their indices, they
can be used as surrogates. This would dispense the need for calculating hundreds of co-
variances. Any movement in security prices could be understood with the help of index
movement. Further, it needs 3N+2 bits of information compared to (N+[N+3]/2) bits of
information needed in the Markowitz analysis.
SINGLE INDEX MODEL
Casual observation of the stock prices over a period of time reveals that most of the
stock prices move with the market index. When the Sensex increases, stock prices also tend to
increase and vice-versa. This indicates that some underlying factors affect the market index as
well as the stock prices. Stock prices are related to the market index and this relationship could
be used to estimate the return on stock. Towards this purpose, the following equation can be
used,
Ri = α i + β i Rm + e i

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 Where Ri = Expected Return on Security i
αi = Intercept of the straight line or alpha co-efficient.
βi = Slope of straight line or beta co-efficient.
Rm = The rate of return on market index.
ei = Error term.
As per the above equation, the return of a stock can be divided into two components, the
return due to the market and the return independent of the market. β1 indicates the sensitiveness
of the stock return to the changes in the market return. For example, β i of 1.5 means that the
stock return is expected to increase by 1.5% when the market index return increases by 1% and
vice-versa. Likewise, βi of 0.5 expresses that the individual stock return would change by 0.5
percent when there is a change of 1 percent in the market return. β i of 1 indicates that the market
return and the security return are moving in tandem. The estimates of β i and αi are obtained from
the regression analysis.
The Single index model is based on the assumption that stocks vary together because of
the common movement in the stock market and there are no effects beyond the market (i.e any
fundamental factor effects) that accounts the stocks movement. The expected return, standard
deviation and co-variance of the single index model represent the joint movement of securities.
The mean return is
Ri = α i + β i Rm + e i
The variance of security’s return, σ2 = βi2 σ2m + σ2ei
The co-variance of returns between securities i and j is
σij = βi βj σ2m
The variance of the security has two components namely, systematic risk or market risk
and unsystematic risk or unique risk. The variance explained by the index is referred to as
systematic risk. The unexplained variance is called residual variance or unsystematic risk.
Systematic risk = βi2 x Variance of market index.
= βi2 x σ2m
Unsystematic risk = Total variance – Systematic risk
ei2 = σi2- systematic risk
Thus, the total risk= Systematic risk + Unsystematic risk
= βi2 σ2m + ei2

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From this, the portfolio variance can be derived

N N
σp = (∑ xi βi¿ x x m¿+( ∑ x i e i x )
2 2 2 2 2

i=1 i=1

σ2= Variance of Portfolio

σp2= Expected variance of index.
σ2m = Variation in security’s return not related to the market index.
xi = The portion of stock i in the portfolio.

Likewise expected return on the portfolio also can be estimated. For each security αi + and βi
should be estimated.
N
Rp = ∑ xi ¿ ¿ Rm)
i=1

Portfolio return is the weighted average of the estimated return for each security in the portfolio.
The weights are the respective stock’s proportions in the portfolio.
A portfolio’s alpha value is a weighted average of the alpha values for its component securities
using the proportion of the investment in a security as weight.
N
σp=∑ xi αi
i=1

Where, αp = value of the alpha for the portfolio

xi = proportion of the investment on security i
αi = value of alpha for security i
N = The number of securities in the portfolio.
Similarly, a portfolio’s beta value is the weighted average of the beta values of its component
stocks using relative share of them in the portfolio as weights.
N
βp=∑ xi βi
i=1

βp is the Portfolo Beta .

CORNER PORTFOLIO

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 The entry or exit of a new stock in the portfolio generates a series of corner portfolio. In
an one stock portfolio, it itself is the corner portfolio. In a two stock portfolio, the minimum
attainable risk (variance) and the lowest return would be the corner portfolio. As the number of
stocks increases in a portfolio, the corner portfolio would be the one with lowest return and risk
combination.

Corner Portfolio

Rp

R B
2

14

A 15

0 S σp

In the above diagram, AB line shows the risk-return combinations of several portfolios. Each
number indicates the number of stocks in the portfolio. When the number of stock increases, the
risk and return decline. Tracing down the AB line shows the corner portfolio. An efficient
frontier may have one or two security portfolio at the low or high extremes, if the percentages of
allocation to stocks are free to take any value.
SHARPE’S OPTIMAL PORTFOLIO

Sharpe had provided a model for the selection of appropriate securities in a portfolio. The
selection of any stock is directly related to its excess return-beta ratio

Ri - Rƒ

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 βi

Where,

Ri = the expected return on stock i

Rƒ = the return on a riskless asset

βi = the expected change in the rate of return on stock i associated with one unit change in the
market return

The excess return is the difference between the expected return on the stock and the
riskless rate of interest such as the rate offered on the government security or treasury bill. The
excess return to beta ratio measures the additional return on a security (excess of the riskless
asset return) per unit of systematic risk or non-diversifiable risk. This ratio provides a
relationship between potential risk and reward.
Ranking of the stocks are done on the basis of their excess return to beta. Portfolio
managers would like to include stocks with higher ratios. The selection of the stocks depends on
a unique cut-off rate such that all stocks with higher ratios of Ri – Rƒ/ βi are included and the
stocks with lower ratios are left off. The cut-off point is denoted by C.
The steps for finding out the stocks to be included in the optimal portfolio are given below
i) Find out the “excess return to beta” ratio for each stock under consideration.
ii) Rank them from the highest to the lowest.
iii) Proceed to calculate Ci for all the stocks according to the ranked order using the
following formula.
σ²мΣᴺᵢ= 1 (Ri – Rƒ) βi
Ci σ²ei
1+σ²m Σᴺᵢ= 1 βi
σ²ei
σ²м = variance of the market index
σ²ei = variance of a stock’s movement that is not associated with the movement of market
index i.e. stock’s unsystematic risk.
iv) The cumulated values of C start declining after a particular C and that point is taken as
the cut-off point and that stock ratio is the cut-off ratio C.
This is explained with the help of an example.

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 Data for finding out the optimal portfolio are given below

Security Mean Excess Beta Unsystematic Excess return

Number Return Return β Risk To beta
Rᵢ Ri – Rƒ σ²ei Ri - Rƒ
βi

1 19 14 1.0 20 14
2 23 18 1.5 30 12
3 11 6 0.5 10 12
4 25 20 2.0 40 10
5 13 8 1.0 20 8
6 9 4 0.5 50 8
7 14 9 1.5 30 6

The riskless rate of interest is 5 percent and the market variance is 10. Determine the cut-off
point.

Security Ri - Rƒ (Ri – Rƒ) βi Σᴺᵢ= 1 (Ri – Rƒ) βi β²ı Σᴺᵢ= 1 β²ı Ci

Number σ²eᵢ σ²eᵢ
βi σ²ei σ²ei
1 2 3 4 5 6 7

1 14 0.7 0.7 0.05 0.05 4.67

2 12 0.9 1.6 0.075 0.125 7.11
3 12 0.3 1.9 0.025 0.15 7.60
4 10 1.0 2.9 0.1 0.25 8.29
5 8 0.4 3.3 0.05 0.3 8.25
6 8 0.04 3.34 0.005 0.305 8.25
7 6 0.45 3.79 0.075 0.38 7.90

Cᵢ calculation are given below

For Security 1

Cı = 10 x .7 = 4.67

1+ (10 x .05)

Here 0.7 is got from column 4 and 0.05 from column 6. Since the preliminary calculations are
over, it is easy to calculate the Cᵢ

C2 = 10 x 1.6 = 7.11

99
 1 + (10 x .125)

C3 = 10 x 1.9 = 7.6

1 + 10 (0.15)

C4 = 10 x 2.9 =8.29

1 + 10(0.25)

C5 = 10 x 3.3 = 8.25

1 + 10(0.3)

C6 = 10 x 3.34 = 8.25

1 + 10 (0.305)

C7 = 10 x 3.79 = 7.90

1 + 10 (0.38)

The highest Cᵢ value is taken as the cut-off point i.e. C*. The stocks ranked above C* have high
excess returns to beta than the cut-off Cᵢ and all the stocks ranked below C* have low excess
returns to beta. Here, the cut-off rate is 8.29. Hence, the first four securities are selected. If the
number of stocks is larger there is no need to calculate Cᵢ values for all the stocks after the
ranking has been done. It can be calculated until the C* value is found and after calculating for
one or two stocks below it, the calculations can be terminated.
The Cᵢ can be stated with mathematically equivalent way.
βip( R p−Rƒ)
Cᵢ=
βi
βip - the expected change in the rate of return on stock I associated with 1 per cent change in the
return on the optimal portfolio
Rp – the expected return on the optimal portfolio
βip and Rp cannot be determined until the optimal portfolio is found. To find out the optimal
portfolio, the formula given previously should be used. Securities are added to the portfolio as
long as

Rᵢ−Rƒ
>Cᵢ
βᵢ

100
Now we have,
Rᵢ-Rƒ >βᵢp (Rp-Rƒ)
The right hand side is the expected excess return on a particular stock based on the expected
performance of the optimum portfolio. The term on the left hand side is the expected excess
return on the individual stock. Thus, if the portfolio manager believes that a particular stock will
perform better than the expected return based on its relationship to optimal portfolio, he would
add the stock to the portfolio.
CONSTRUCTION OF THE OPTIMAL PORTFOLIO

After determining the securities to be selected, the portfolio manager should find out how
much should be invested in each security. The percentage of funds to be invested in each security
can be estimated as follows

Zᵢ
ᴺ
Xi =
∑ Zᵢ
i=1

βᵢ
Zi = ¿
σ ² ei

The first expression indicates the weight on each security and they sum upto one. The second
shows the relative investment in each security. The residual variance or the unsystematic risk has
a role in determining the amount to be invested in each security.
Taking up the previous example

1
Zı =
20
(14 – 8.29) = 0.285

1.5
Z2 =
30
(12 – 8.29) = 0.186

0.5
Z3 =
10
(12 – 8.29) = 0.186

2
Z4 =
40
(10 – 8.29) = 0.086

∑ ¿ 0.285 + 0.186 + 0.186 + 0.086

i=1

101
 = .743

0.285
Xı = = 0.38
0.743

0.186
X2 = = 0.25
0.743

0.186
X3 = = 0.25
0.743

0.086
X4 = = 0.12
0.743

Thus, the proportions to be invested in different securities are obtained. The largest investment
should be made in security 1 and the smallest in security 4.
Problems on Sharpe’s Model
1.How many inputs are needed for a portfolio analysis involving 40 securities, for Sharpe and
Markowitz models?
Solution
Sharpe = (3 N) +2
= 50 X 3 + 2
=152.
Markowitz = [N (N+3)]/2
= 1325.
2. The following table provides information regarding the portfolio return and risk

Portfoli Expected σ
o Return E(R)
1 10 4
2 12 7
3 13 5
4 16 12
5 20 14

102
 a. The treasury bill rate is 5%. Which portfolio is best?
b. Would it be possible to earn 12% return with σ of 4%?
c. If σ is 12% what would be the expected return?
Solution
The information given is only the Rt, E (R) and σ. With this, the return to risk ratios can
be found out and the highest yielding return to risk ratio can be selected as the best portfolio.
Portfoli [E(R)- R]/ σ
o
1 (10-5)/4=1.25
2 (12-5)/7=1.0
3 (13-5)/5=1.6
4 (16-5)/12=0.92
5 (20-5)/14=1.07
a. The third portfolio yields the highest return for a unit of risk
b. If σ = 4, then the best portfolio will yield
E(R) = 5 + 4(1.6) = 11.4- It may not be possible to get 12% return.
c. If σ = 12
E(R) = 5 + 12(1.6) = 24.2
3. An investor wants to build a portfolio with the following four stocks. With the given details.
find out his portfolio return and portfolio variance. The investment is spread equally over the
stocks.

Company α β Residual Variance

S 0.17 0.93 45.15
N 2.48 1.37 132.25
A 1.47 1.73 196.28
P 2.52 1.17 51.98

Market Return (Rm) = 11

Market Return Variance = 26.

Solution
N
Portfolio Return Rp = ∑ Xi( αi+ βi Rm)
I=1

R1= 0.17+0.93 (11) = 10.4

R2 = 2.48 + 1.37 (11) = 17.55

103
 R3 = 1.47 + 1.73(11) = 20.5
R4 = 2.52 + 1.17 (11) = 15.4
Rp = 10.4x0.25 + 17.55x0.25 + 20.5x0.25 + 15.4x0.25
= 2.6 + 4.39 + 5.125 + 3.85
= 15.965.
σ 2 p=¿
= (0.25x0.93 + 0.25x1.37 + 0.25x1.73 + 0.25x1.17)2
= (0.2325 + 0.3425 + 0.4325 + 0.2925)2
= (1.3)2

=1.69x26
=43.94.

=(0.25)2 (45.15) + (0.25)2 (132.25) + (0.25)2 (196.29) + (0.25)2 (51.98)

=2.822 + 8.266 + 12.269 + 3.249
= 26.606.

2
σ p = 43.94 + 26.606
= 70.546.
σp=8.399

4. Stocks L and M have yielded the following returns for the past two years.

Years Return
%
L M
1995 12 14
1996 18 12

a) What is the expected return on portfolio made up of 60 percent of L and 40 percent of M?

b) Find out the standard deviation of each stock
c) What is the co variance and co - efficient correlation between stock Land M?
d) What is the portfolio risk of a portfolio made up of 60 percent of L and 40 Per cent of M?

Solution:

a) Expected rate of return

104
 = ΣR
n
ΣR is the total of return n-number of observation
Returns of stock L = 12 + 18 = 15
2
Stock M = 14 + 12 =13
2

Portfolio return = Σᴺί=ı Xı Rı

Xı being the proportion held by each security which includes 60% of L and 40% of M

= (0.6 + 15) + (0.4 x 13)

= 9 + 5.2 =14.2

b) Standard deviation of each stock

√
2
σ= Σ ( R ı=R ̅ ı )
ɴ

√
2 2
= ( 12−15 ) + ( 18−15 ) = √ 9+9 / 2
2

σʟ=3

√
2
σм = Σ ( R м−R ̅ м )
2

√
2 2
= ( 14−13 ) + ( 12−13 ) =√ 2/2 =√ 1
2

σm= 1

c) The co-variance between stock L and M

Cov ʟм = Σ(Rı -R̅ı) (Rм-R̅м)

105
 = (-3) + (-3) = -6 = -3

Correlation co-efficient is

r = CovarianceLM

σʟ σm

= -3 -1

3x1

√
d) Portfolio risk σp = ( X ı )2 ( σ ı )2 +( X ₂) ²(σ ₂) ²+2 X ı X 2 (r ı₂ σ ıσ ₂)

σp =√ σp ²

√
σp = ( .6 )2 × 9+ ( 0.4 )2 × 1+ 2× .6× .4 ׿ ¿
=3.24 + 0.16 + (-1.44)
=√ σ ² p =√ 1.96 = 1.4

5.Stocks Y and Z have the following parameters

Stock Y Stock Z
Expected return 20 30

Expected variance 16 25

Covariance 20

Is there any advantage of holding a combination of Y and Z?

Solution:

There is no advantage of holding a combination Y and Z, as risk cannot be reduced they are perfectly
positively correlated.

r = covariance yz

106
 σy σz

σy = √ variance y =√ 16 = 4

σz = √ variance z = √ 25 = 5

r = 20 = +1

4x5

6. The expected rate of return and the possibilities of their occurrence for Alpha company and Beta
company scrips are given below

Probability of occurrence Return on Alpha’s Return on Beta’s Scrip

Scrip
0.05 -2.0 -3.0
0.20 9.0 6.0
0.50 12.0 11.0
0.20 15.0 14.0
0.05 26.0 19.0

(a) Find out the expected rates of return for Alpha and Beta scrips.
(b) If an investor invests equal proportion on both the scrips what would be the return?
(c) If the proportion is changed to 25% and 75 % and then to 75% and 25% what would be
the expected rates of return.
Solution

a) R=Σ ᴺᵢ ˍ ₁ R ₁ P ₁

Return on Alpha’s scrip =R₁(P₁)+R₂(P₂)=R₃(P₃)+R₄(P₄)+R₅(P₅)

=-2.0(.05) +9.0(.20) +12(0.50) +15(.2) +26(.05)
=12%
Return on Beta’s scrip = -3.0(.05) +6(.2) +11(.5) +14(.2) +19(.05)
=10.3%
b) If an investor invests equal proportion of 50%, then

107
 R ᴘ=Σ ᴺᵢ ˍ ₁ R ₁ P ₁
Rᴘ= .5 x 12 + .5 x 10.3
Rᴘ= 6 + 5.15 =11.15
c) 75% of Alpha security and 25% of Beta security
Rᴘ =.75 x 12 + .25 x 10.3
= 9 +2.575 =11.575
25% of Alpha security and 75% of Beta security
Rᴘ=.25 x 12+ .75 x 10.3
= 3 + 7.725 =10.72

Capital Asset pricing Model

Harry Markowitz developed an approach that helps an investor to achieve his optimal portfolio
position. Hence, portfolio theory, in essence, has a normative character as it prescribes what
rational investors should do.
William Sharpe and others asked the follow – up question: If rational investors follow the
Markowitzian prescription, what kind of relationship exists between risk and return? Essentially,
the capital asset price in model (CAPM) developed by them is an exercise in positive economics.
It is concerned with two key questions:
 What is the relationship between risk and return for an efficient portfolio?
 What is the relationship between risk and return for an individual security?
The CAPM, in essence, predicts the relationship between the risk of an asset and its expected
return. This relationship is very useful in two important ways. First, it produces a benchmark for
evaluating various investments. For example, when we are analyzing a security we are interested
in knowing whether the expected return from it is in line with its fair return as per the CAPM.
Second, it helps us to make an informed guess about the return that can be expected from an
asset that has not yet been traded in the market. For example, how should a firm price its initial
public offering of stock?
Although the empirical evidence on the CAPM is mixed, it is widely used because of the
valuable insight it offers and its accuracy is deemed satisfactory for most practical application.
No wonder, the CAPM is a centerpiece of modern financial economics and William Sharpe, its
principal originator, was awarded the Nobel Prize in Economics.

108
 This chapter discusses various aspects of the CAPM, explains the basics of Arbitrage Pricing
Theory (APT) and multifactor models which have been proposed as an alternative to the CAPM,
and finally describes the stock market as a complex adaptive system.

 Basic Assumptions
The CAPM is based on the following assumptions:
 Individuals are risk averse.
 Individuals seek to maximize the expected utility of their portfolio over a single period
planning horizon.
 Individuals have homogeneous expectations-they have identical subjective estimates of
the mean, variances, and covariance’s among returns.
 Individuals can barrow and lend freely at a riskless rate of interest.
 The market is perfect: there are no taxes; there are no transaction costs; securities are
completely divisible; the market is competitive.
 The quantity of risky securities in the market is given.
Looking at these assumptions, one may feel that the CAPM is unrealistic. However, the value of
a model depends not on the realism of its assumption, but on the validity of its conclusion.
Extensive empirical analysis suggests that there are merits in the CAPM.
 Capital Market Line
The rational investors would choose a combination of Rf and S(S represent the point on the
efficient frontier of risky portfolios where the straight line emanating from Rf is tangential
to the efficient frontier). If all investors attempt to purchase the securities in S and ignore
securities not included in S would rise and hence their expected return will fall. This would
shift S, along with other points which share securities with S, downwards: On the other
hand, prices of securities not included in S will fall, leading to an increase in their expected
return. Consequently, points representing portfolios in which these securities are included
will shift upwards. As this process continues, the efficient frontier of risky securities will
flatten as shown in Exhibit 1. Finally, the set of prices reached would be such that every
securities will enter at least one portfolio on the linear segment KML, of course, the market
portfolio would itself be a point on that linear segment.

109
 Portfolios which have returns that are perfectly correlated with the market portfolio are
referred to as efficient portfolios. Obviously, these are portfolios that lie on the linear
segment.

Exhibit 1 Adjustment of the Efficient Frontier

Expected return, E(Rp)

z
M

K
Rf

Standard deviation,σP

For efficient portfolios (which include the market portfolios) the relationship between risk and
return is depicted by the straight line Rf MZ. The equation for this line, called the capital market
line (CML), is:
E(Rί)=Rƒ+λσί
Where E(Rj) is the expected return on portfolio j, Rƒ is the risk-free rate,λ is the slope of the
capital market line, and σj is the standard deviation of portfolio j.
Given that the market portfolio has an expected return of E(Rм) and standard deviation of σм,
the slope of the CML can be obtained as follows:

110
 λ = E (Rм) – Rƒ
σм

where λ, the slope of the CML, may be regarded as the “price of risk” in the market.
 Security Market Line
There is a simple linear relationship between the expected return and standard deviation.
What about individual securities and inefficient portfolios? Typically, the expected return
and standard deviation for individual securities will be follow the CML., reflecting
inefficiency of undiversified holdings. Further, such points would be found throughout the
feasible region with no well-defined relationship between their expected return and standard
deviation. However, there is a linear relationship between their expected return and the
covariance with the market portfolio. This relationship, called the Security Market Line
(SML), is as follows:

E(Rί)=Rƒ + E(Rм)-Rƒ σίм

σ²м
where E(Ri) is the expected return on security I,Rf is the risk free return,E(Rm) is the
expected return on market portfolio,σ2m is the variance of return on market portfolio, and
σim is the covariance of returns between security i and market portfolio.
In words, the SML relationship says:
Expected return on security i=Risk-free return+ (price per unit of risk)Risk
The price per unit of risk is: E (Rм)-Rƒ
σ²м
The measures of risk is: σim
In the Equation, the risk of a security is expressed in terms of its covariance with the market
portfolio, σίм
Can we find a standardized measure of risk? Fortunately, we can find a standardized
measure of systematic risk, popularly called beta ( β ), by taking advantage of the
relationship.
β ί= σίм
σ²м

111
 β i reflects the slope of a linear regression relationship in which the return on security i is
regressed on the return on the market portfolio.
Thus , the SML is popularly expressed as

E(Rί)= Rƒ+ [E(Rм)-Rƒ] β ί

In words, SML relationship says:

Expected Return on security I = Risk-free return+ Market risk premium+ Beta of security i
The SML which reflects the expected return-beta relationship is shown in Exhibit 2. Note
that the slope of the SML, is the market risk premium.
Exhibit 2 The Security Market Line
Return (%)

p SML
14

8 o

Assets which are fairly priced plot exactly on the SML. Underpriced securities (such as P) plot
above the SML, whereas overpriced securities (such as O) plot below the SML. The difference
between the actual expected return on security and its fair return as per the SML is called the
security’s alpha, denoted by α .
 Relationship between SML and CML
Note that the CML relationship is a special case of the SML relationship. This point may be
demonstrated as follows:

As per the SML

E(Rί) = Rƒ + E(Rм)-Rƒ σίм

112
 σ²м
Since σίм = Pίм σί σм, Eq.(8.3) can be re-written as:

E(Rί) = Rƒ + E(Rм)Rƒ Pίм σί

σм
If the returns on I and M are perfectly correlated (this is true for efficient portfolio), Eq,(8.6)
becomes:

E(Rί) = Rƒ + E(Rм)-Rƒ σί
σм
This is nothing but the CML. Hence the CML is a special case of the SML.
INPUTS REQUIRED FOR APPLYING CAPM
To apply the CAPM, you need estimates of the following factors that determine the CAPM
line:
 Risk – Free Rate
The risk-free rate is the return on a security (or portfolio of securities) that is free from
default risk and is uncorrelated with returns from anything else in the economy.
Theoretically, the return on zero-beta portfolio is the best estimate of the risk-free rate.
Constructing zero-beta portfolios, however, is costly and complex. Hence, they are often
unavailable for estimating the risk-free rate.
In practice, two alternatives are commonly used:
 The rate on a short-term govt, securities like the 364-days Treasury bill.
 The rate on a long-term govt, bond that has a maturity of 15 to 20 years.
Both the alternatives have their advantages and limitations. The choice may depend largely on
the judgement of the analyst.
 Market Risk Premium
The risk premium used in the CAPM is typically based on historical data. It is calculated as
the difference between the average return on stocks and the average risk-free rate. Two
measurement issues have to be addressed in this context: How long should the measurement
period be? Should arithmetic mean or geometric mean be used?

113
 The answer to the first question is: Use the longest possible historical period, absent any
trends in risk premium over time.
Practitioners seem to disagree over the choice of arithmetic mean versus geometric mean.
The arithmetic mean is the average of the annual rate of returns over the measurement
period whereas the geometric mean is the compounded annual return over the measurement
period. The difference between the two may be illustrated with a simple example where we
have two years of returns:

Year Price Return

0 100
1 180 80%
2 135 -25%
The arithmetic mean over the two years is 27.5% [(80-25)/2], whereas the geometric mean
is only 16.2% (1.350.5-1=1.162). The advocates of arithmetic mean argue that it is more
consistent with the mean-variance frame work and can be better predict the premium in the
next period. The votaries of geometric mean argue that it takes into account compounding
and can better predict the average premium in the long term. It appears that the arithmetic
mean is more appropriate.

What Drives the Market Risk Premium?

Three factors seem to influence the market risk premium, in the main:
 Variance in the Underlying Economy if the underlying economy is more
volatile, the market risk premium is likely to be large. For Example, the
market risk premiums for emerging markets, given their high-growth and high-
risk economies are larger than the market risk premiums for developed
markets.
 Political Risk market risk premiums are larger in markets subject to higher
political instability. Remember that political instability causes economic
uncertainty.
 Market Structure If the companies listed on the market are mostly large,
stable, and diversified, the market risk premium is smaller. On the other hand,

114
 if the companies listed on the market are generally small and risky, the market
risk premium is larger.

 Beta
The beta of an investment I is the slope of the following regression relationship:
Rit = σi + β i Rmt+ eίᵼ

Where Rίᵼ is the return on investment ί ( a project or a security) in period t, Rʍᵼ is the return on
the market portfolio in period t, α ί is the intercept of the linear regression relationship between
Rίᵼ and Rʍᵼ (α is pronounced as alpha), β ί is the slope of the linear regression relationship
between Rίᵼ and Rʍᵼ ( β is pronounced as beta)
The variance of Rίᵼ as per Eq. (8.8) is:
Var (Rίᵼ) = β ² ί σ ʍ ² + Var(eίᵼ)
From the above equation, we find that the total risk associated with investment i, as measured by
its variance, is the sum of two components: i) The risk associated with the responsiveness of the
return on the investment to market index: βi σM 2 and ii) The risk associated with the error term:
var (eit). The first component represents the systematic risk and the second, unsystematic risk.
Systematic risk stems from economy wide factors which have a bearing on the fortunes of all
firms whereas unsystematic risk emanates from firm-specific factors. While systematic risk
cannot be diversified away, unsystematic risk can be. Hence, the relevant risk, as per the CAPM,
is the systematic risk. It is also referred to as non-diversifiable risk or market risk.
ARBITRAGE PRICING THEORY
Arbitrage Pricing Theory is one of the tools used by the investors and portfolio
managers. The capital asset pricing theory explains the returns of the securities on the basis of
their respective betas. According to the previous models, the investor chooses the investment on
the basis of expected return and variance. The alternative model developed in asset pricing by
Stephen Ross is known as the Arbitrage Pricing Theory. The APT theory explains the nature of
equilibrium in the asset pricing in a less complicated manner with fewer assumptions compared
to the CAPM.
Arbitrage It is the process of earning profit by taking advantage of differential pricing for the
same asset. The process generates riskless profit. In the security market, it is of selling security

115
 at a high price and the simultaneous purchase of the same security at a relatively lower price.
Since the profit earned through arbitrage is riskless, the investors have the incentive to
undertake this whenever an opportunity arises. In general, some investors indulge more in this
type of activities than others. However, the buying and selling activity of the arbitrageur reduce
and eliminates the profit margin, bringing the market price to the equilibrium level.
The Assumptions
i) The investors have homogenous expectations.
ii) The investors are risk averse and utility maxi misers.
iii) Perfect competition prevails in the market and there is no transaction cost.
The APT theory does not assume a) Single period investment horizon b) No taxes
c) Investors can borrow and lend at risk free rate of interest. d) The selection of the
portfolio is based on the mean and variance analysis.
Arbitrage Portfolio
According to the APT theory, an investor tries to find out the possibility to
increase returns from his portfolio without increasing the funds in the portfolio. He also likes to
keep the risk at the same level. For example, the investor holds A, B and C securities and he
wants to change the proportion of the securities without any additional financial commitment.
Now the change in proportion of securities can be denoted by XA, XB and XC. The increase in
the investment in security A could be carried out only if he reduces the proportion of
investment either in B or C because it has already stated that the investor tries to earn more
income without increasing his financial commitment. Thus, the changes in different securities
will add up to zero. This is the basic requirement of an arbitrage portfolio. If X indicates the
change in proportion,
∆ XA+∆ XB+ ∆ XC =0
Problems on Capital Asset Pricing Model

1. Assume that the risk free rate of return is 7 percent. The market portfolio has an expected
return of 14 per cent and a standard deviation of return of 25 percent. Under equilibrium
conditions as described by CAPM, what would be the expected return for a portfolio
having no unsystematic risk and 20 percent standard deviation of return?
Solution

116
 Rᵢ = Rƒ + [ Rᵢ−Rƒ
σm ]σᵢ
= .07 + [ .14−.07
.25 ]
×.2

= .126
2. Assume yourself as a portfolio manager and with the help of the following details find
out the securities that are overpriced and underpriced in terms of the security market line.

Security Expected Return β σ

A .33 1.7 .50
B .13 1.4 .35
C .26 1.1 .40
D .12 .95 .24
E .21 1.05 .28
F .14 .70 .18
Nifty Index .13 1.00 .20
T-Bills .09 0 0.0

Solution
The return on the SML can be estimated with the help of the formula
Rᵢ =Rƒ +βı (Rm –Rƒ)
A security
Rƒ = .09 + 1.7 (.13-.09)
= .158
Likewise, the return on SML line is estimated and given in the table as given below

Security Expected Return Estimated Return Remarks

A .33 .158 Underpriced
B .13 .146 Overpriced
C .26 .134 Underpriced
D .12 .128 Overpriced

117
 E .21 .132 Underpriced
F .15 .118 Underpriced

3. (i) Assume that a portfolio is constructed by using equal portion of the six stocks listed in Q.2 and
find out the expected return (ii) what would be the expected return and risk if this portfolio were
margined at 50 per cent with the cost of borrowing at 9per cent?

Solution
N
i) E(R) = ∑ XᵢRı
i=1

= 1/6 x.33 + 1/6 x.13 +1/6 x.26 +1/6 x.12 +1/6 x.21+1/6 x.15
= .2
ii) If 50% of the funds are borrowed
= -.09 x .5 +.2 = .155

Rp = Rƒ+ [
Rm−Rƒ
σm
σp
]
.04 σ p
.155 =.09 +
.2
σ p = .325
4. The following assets are assumed to be correctly priced on the security market line, what
is the return of the market portfolio? What is the risk free rate of return?
Rı =9.40% βı = .80
R2 =13.40% β2 = 1.30
Solution
Since the two assets are assumed to be on the SML by solving the following equation Rᴍ
and Rf can be found out.
Rı = Rf + β (Rm - Rf)
9.4 = Rf + .8 (Rm - Rf)
13.4 = Rf + 1.3 (Rm - Rf)
9.4 = .2Rf + .8Rm ………… (1)
13.4 = .3Rf + 1.3Rm ………. (2)
Multiply equation one with 1.5
14.1 = .3Rf + 1.2Rm
13.4 = -.3Rf + 1.3Rm
add both the equations

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 27.5 = 2.5 Rm
Return on market portfolio (Rm) =11
Substituting Rm in any of the equation will give Rf
9.4 = Rf + .8(11- Rf)
9.4 = Rf + 8.8 -.8 Rf
9.4-8.8 = .2 Rf
0.6
Rf =
.2
=3
Rm is 11%, Rf is 3%
5. Assume the CAPM with risk free lending but not risk free borrowing. The return on the
market portfolio is 10% and the return on the zero beta portfolio is 6%. The market
standard deviation is 30%. Complete the following table.

Security Expected Standard Beta Residual

Return Deviation variance
X .15 ________ ______ .0375
Y .10 ________ _______ .0775

Solution
The SML market line equation is
R = σ + β (Rm)
σ = return on the zero beta portfolio

X Security
.15 = .06 + β (.10)
.04
β=
.1
=.4
Y Security
.1= .06 + β (.10)
.04
=
.1
=.4

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 Standard deviation =√ β ² × variance of index+ e ² ı

X Security =√ ( . 92 ×. 32 ) +.0375
=√ 0.1104
= .332

Y Security = √ ( 0.4 2 × 0.32 ) +0.0775

= √ 0.0919
= 0.303

Security Expected σ β e²ᵢ

Return
X .15 .332 .9 .0375
Y .11 .303 .5 .0775

Review Questions
1. What do you mean by Portfolio construction?
2. Explain the different approaches to portfolio construction.
3. Bring out the steps involved in traditional approach of portfolio construction.
4. Elucidate in detail the salient features of Markowitz model.
5. Write short notes on the Sharpe Single Index model of portfolio analysis.
6. What do you mean by Capital Asset Pricing Model? Bring out its assumptions.
7. Discuss in detail about Capital Market Line and Security Market Line.
8. Describe the Arbitrage Pricing Theory in detail.

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