1.

What is Risk: - Risk is the possibility of losing something of value. Values (such as physical health, social status,
emotional well-being, or financial wealth) can be gained or lost when taking risk resulting from a given action or
inaction, foreseen or unforeseen (planned or not planned).
2. Sources of risk: -
 Interest rate risk Interest rate risk is the probability of a decline in the value of an asset resulting from
unexpected fluctuations in interest rates. Interest rate risk is mostly associated with fixed-income assets (e.g.,
bonds. In other words, when the interest rate increases, the price of a bond decreases.)  
 Market risk Market risk is the possibility of an investor experiencing losses due to factors that affect the overall
performance of the financial markets in which he or she is involved. Market risk, also called "systematic risk,"
cannot be eliminated through diversification, though it can be hedged against.
 Sources of market risk include recessions, political disorder, and changes in interest rates, natural disasters and
terrorist attacks. Systematic or market risk tends to influence the entire market at the same time.
 Inflation risk Inflation risk, also called purchasing power risk, is the chance that the cash flows from an
investment won't be worth as much in the future because of changes in purchasing power due to inflation.
 Business risk Business risk is the exposure a company or organization has to factor(s) that will lower its profits or
lead it to fail. Anything that threatens a company's ability to meet its target or achieve its financial goals is
called business risk.
 Financial risk financial risk is a term that can apply to businesses, government entities, the financial market as a
whole, and the individual. This risk is the danger or possibility that shareholders, investors, or
other financial stakeholders will lose money. Financial risk is caused due to market movements and market
movements can include host of factors. Based on this, financial risk can be classified into various types such as
Market Risk, Credit Risk, Liquidity Risk, Operational Risk and Legal Risk.
 Exchange rate risk Foreign exchange risk (also known as FX risk, exchange rate risk or currency risk) is
a financial risk that exists when a financial transaction is denominated in a currency other than the domestic
currency of the company. The exchange risk arises when there is a risk of significant appreciation of the domestic
currency in relation to the denominated currency before the date when the transaction is completed.
 Liquidity risk Liquidity risk is the risk that a company or bank may be unable to meet short term financial
demands. This usually occurs due to the inability to convert a security or hard asset to cash without a loss of
capital and/or income in the process.
 Country risk. Economic stability and variability of a country’s economy need to be considered.
3 What is Portfolio? Investing in securities such as shares, debentures, and bonds is profitable as well as exciting.
Portfolio is investing in a group of security rather than a single security in order to minimize the risk.
It is rare to find investors investing their entire savings in a single security. Instead, they tend to invest in a group of
securities. Such a group of securities is called a portfolio. Creation of a portfolio helps to reduce risk without
sacrificing returns. Profit Capital gain + Dividend gain (Share Income).
4. What is Portfolio Management? Portfolio management deals with the analysis of individual securities as well as
with the theory and practice of optimally combining securities into portfolios. An investor who understands the
fundamental principles and analytical aspects of portfolio management has a better chance of success. Portfolio
Management Comprises all the processes involved in the creation and maintenance of an investment portfolio.
5. What are the Steps of Portfolio Management? Portfolio management is a process encompassing many activities
aimed at optimizing the investment of one’s funds. Five phases can be identified in this process:
• Security Analysis: equity share, preference share, creditor-ship securities, such as debenture & bonds. Security
analysis is the initial phase of the portfolio management process. This step consists of examining the risk-return
characteristics of individual securities. A basic strategy in securities investment is to buy underpriced securities and
sell overpriced securities. There are two alternative approaches to security analysis, namely, Fundamental analysis &
technical analysis.
• Portfolio Analysis: consists of identifying the range of possible portfolios. Portfolio analysis phase of portfolio
management consists of identifying the range of possible portfolios that can be constituted from a given set of
securities and calculating their return and risk for further analysis.
• Portfolio Selection: identify the set of efficient portfolios. Portfolio analysis provides the input for the next phase in
portfolio management which is portfolio selection. The inputs from portfolio analysis can be used to identify the set of
efficient portfolios. From this set of efficient portfolios, the optimal portfolio has to be selected for investment.
• Portfolio Revision: constantly monitor the portfolio to ensure the optimal. Having constructed the optimal portfolio,
the investor has to constantly monitor the portfolio to ensure that it continues to be optimal. The investor has to revise
his portfolio in the light of the developments in the market. This revision leads to purchase of some new securities and
sale of some existing securities from the portfolio. The mix of securities and their proportion in the portfolio changes
as a result of the revision.
• Portfolio Evaluation: constructing a portfolio and revising it periodically is to earn maximum returns with
minimum risk. The objective of constructing a portfolio and revising it periodically is to earn maximum returns with
minimum risk. Portfolio evaluation is the process which is concerned with assessing the performance of the portfolio
over a selected period of time in terms of return and risk. Portfolio management process is an ongoing process. It starts
with security analysis, proceeds to portfolio construction, and continues with portfolio revision and evaluation.
6. Efficient portfolio: Generally, investors are risk averse. They will choose the portfolio that offers the highest return
for a given level of risk. According to principle of dominance –
I. A risk-averse investor will prefer a portfolio with the highest expected return for a given level of risk. Or ii. An
investor may prefer a portfolio with the lowest level of risk for a given level of return.
The portfolio which is formed according to the principle of dominance is called an efficient portfolio.
Efficient frontier: The efficient frontier formed by the set of efficient portfolios. Specially, the efficient frontier
represents the set of portfolios that offer maximum rate of return for a given level of risk or the minimum risk for a
given level of return. The efficient frontier is a concave curve in the risk-return space that extends from the minimum
variance portfolio to the maximum return portfolio.
7. Optimum portfolio theory. The optimum portfolio is the efficient portfolio that has the highest utility for a given
investor. It lies in the point of tangency between the efficient frontier and the utility curve with the highest possible
utility. Rational investors will obviously prefer to invest in the efficient portfolios. The investors will select the
portfolio depending on their degree of risk aversion. A highly risk averse investor will hold a portfolio on the lower
left-hand segment of the efficient frontier, while the investor who is not too risk averse will hold one on the upper
portion of the efficient frontier.
The selection of the optimum portfolio depends on the investor’s risk aversion. So the portfolio that gives the highest
utility in the efficient frontier will be the optimum portfolio for that investor.
How do you determine the optimum portfolio? Explain with two curves-
i. Efficient frontier. And ii. Utility curve.
Investors are risk averse. They will choose the portfolio that offers the highest return for a given level of risk.
The efficient frontier formed by the set of efficient portfolios. It represents by the set of efficient portfolios by
specially, the efficient frontier represents the set of portfolios that offer maximum rate of return for a given level of
risk or the minimum risk for a given level of return.

Figure: Efficient frontier

The efficient frontier is a concave in the risk-return space that extends from the variance portfolio to the maximum
return portfolio.
The optimum portfolio is the efficient portfolio that has the highest utility for a given investors. It lies at the point of
the tangency between the efficient frontier and the utility curve with the highest
Possible utility.
Portfolio Expected return

The selection of the optimum portfolio depends on the risk-aversion or conversely on his risk tolerance. Here we
graphically represented it through a series of risk-return utility curves or indifference curves... Each curve represents
different combination of risk & return all of which are equally satisfactory to the concerned investor. Each successive
curve moving upwards to the left represents a higher level of satisfaction or utility.
Investor’s goal would be to maximize his utility by moving up to the higher utility curve. The optimum portfolio for
an investor would be the one at the point of tangency between the efficient frontier and his risk-return utility or
indifference curve. Here in the above graph point-O in the optimum portfolio
8. What is Portfolio Evaluation: -Portfolio Evaluation is the last stage in Portfolio management where the investors
examine to what extend the objective of “maximizing return & minimizing risk” has been achieved. Portfolio
Evaluation tries to find out how well the Portfolio has performed.
 9. Portfolio Evaluation is the evaluation of the performance of the portfolio. It is the process of comparing the return
earned on a portfolio with other portfolios. It comprises two functions.
i) Performance measurement: - Performance measurement measures the return earned on portfolio during the
investment period.
ii) Performance Evaluation: - Performance evaluation address such issues as whether the performance was superior or
inferior, whether the performance was due to skill or luck, etc.
10. Different measures of portfolio evaluation: -
i) Sharp’s measures.
ii) Treynor’s measures.
iii) Jensen measures.
i) Sharp’s measures. William Sharpe developed a risk-adjusted measure of portfolio performance known as the sharp
ratio or the reward to variability ratio (RVAR). It is the rate of the reward or risk premium to the variability measured
by the standard deviation. (Total risk)
Sharpe’s measure talks about the following points -------
 It measures the excess return per unit of total risk (standard deviation).
 The higher the RVAR, the better the portfolio performance.
 Portfolios can be ranked by RVAR.
 Sharp ratio (SR)= (Rp-Rf)/σ
ii) Treynor’s measures. The performance measure developed by Jack Treynor is referred to as Treynor ratio or
reward to volatility ratio (RVOL). It is the ratio of the reward or risk premium to the volatility of return. Here the risk
is measured by Beta.
 Treynor distinguished between total risk and systematic risk, implicitly assuming that portfolios are well diversified,
that is he ignores any diversifiable risk.
 Treynor measure relates the average excess return on the portfolio during some period to its systematic risk as
measured by the portfolio’s beta.
 Treynor measure talks about the following points ----------
 It measures the excess return per unit of systematic risk (Beta).
 The higher the RVOL, the better the portfolio performance.
 Portfolios can be ranked by RVOL.
 Treynor ratio (TR) = (Rp-Rf)/β
iii) Jensen differential return measure. The performance measure that has been developed by Michael Jensen is
referred to as the Jensen differential return measure or (Alpha) ratio. This ratio measures the differential between the
actual return earned on a portfolio and the return expected from the portfolio given its level of risk.
 The CAPM model is used to calculate the expected return on a portfolio that indicates the return that a portfolio
should earn for its given level of risk.
E (Rp) = Rf+ (Rm-Rf) xβi
11. The differential return is the excess return that has been earned over & above what is mandated for its level of
systematic risk. The differential return gives an indication of the portfolio manager’s predictive ability or management
skills.
 12. Treynor Versus sharp measure: -
The sharp portfolio performance measure uses the standard deviation of return as the measure of total risk.
 The Treynor performance measure uses beta as the measure of systematic risk.
 For a completely diversified portfolio the two measures give identical (same) ranking because the total variance of the
completely diversified portfolio is its systematic variance.
 A poorly diversified portfolio could have a high ranking on the basis of the Treynor performance measure but a much
lower ranking on the basis of the sharp performance measure. Any difference in rank would come directly from a
difference in diversification.
 Here in our example portfolio S & R are well diversified portfolio. So, they give the same ranking. But portfolio P &
Q are poorly diversified portfolios. So, they rank differently.