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Corporate Finance- 1

Efficient Frontier for a Portfolio

HCL, IOCL, PNB, Emami

Submitted to Submitted by

Prof. S.K.Ganguli Section F Group 6

ATUL GARG (11FN-126)

DEEPSHIKHA AGARWAL (11FN-033)

NIRAJ SATNALIKA (11IB-038)

RAHUL KUMAR (11DM-118)

RAVI RANBIR (11DM-123)

SAHIL GOEL (11DM-131)

Corporate Finance Section-F, Group-6

IMT Ghaziabad Page 2

Objective:-

To track a multi-share portfolio consisting of four stocks traded on the open market:

1. HCL Technologies (BSE: 532281 | HCLTECH)

2. Indian Oil Corporation Limited ((BSE: 530965 l IOCL)

3. Punjab National Bank (BSE :532461 l PNB )

4. EMAMI Ltd. (BSE:531162 l EMAMI LTD)

And chart their five year-by-year returns, calculate the returns, variance and standard

deviations along with the covariance between them and thus plot the efficient frontier for the

portfolio.

Companies at a glance:

1. HCL Technologies is a leading global IT services company, working with clients in the areas

that impact and redefine the core of their businesses. Since its inception into the global

landscape after its IPO in 1999, HCL focuses on 'transformational outsourcing', underlined by

innovation and value creation, and offers integrated portfolio of services including software-led

IT solutions, remote infrastructure management, engineering and R&D services and BPO.

2. Indian Oil Corporation limited:- Indian Oil Corporation Ltd. is India's largest company by

sales with a turnover of Rs. 3,28,744 crore ($ 72,125 million) and profit of Rs. 7445 crore ($

1,633 million) for the year 2010-11. Indian Oil is the highest ranked Indian company in the latest

Fortune ͚Global 500͛ listings, ranked at the 98th position. Indian Oil͛s vision is driven by a group

of dynamic leaders who have made it a name to reckon with.

3. Punjab National Bank:- Since its humble beginning in 1895 with the distinction of being the

first Swadeshi Bank to have been started with Indian capital, PNB has achieved significant

growth in business which at the end of March 2011 amounted to Rs 5,55,005 crore. PNB is

ranked as the 2nd largest bank in the country after SBI in terms of branch network, business

and many other parameters.

4. Emami Group, a conglomerate born out of Bengal has a pan India presence through its

battery of brands and business initiatives that blossomed under the parentage of Mr. R S

Agarwal and Mr. R S Goenka since 1974. With an aggregate group turnover of about Rs 3700

crore the group has business interests in FMCG (fast moving consumer goods), paper , writing

instruments, edible oil and cultivation, bio-diesel, hospitals, contemporary art, pharmacy,

cement, real estate and retail. The Group͛s fountain of strength are its ingrained value system,

innovativeness and an over 20,000 passionate and dedicated staff, engaged in knowledge

sharing.

Corporate Finance Section-F, Group-6

IMT Ghaziabad Page 3

Emami Limited, the flagship company of the Group, is a coveted Rs 1300 crore business entity ,

a leading player in the personal and healthcare consumer products industry in India engaged in

manufacturing and marketing of health, beauty and personal care products that are based

entirely on ayurvedic formulation.

Emami Limited has over 30 brands under its portfolio. The focus is on providing the consumers

with innovative products which are capable of meeting their multiple needs and add value by

enhancing the quality of day-to-day life.

Returns: - Return is the ratio of money gained or lost (whether realized or unrealized) on

an investment relative to the amount of money invested. The Expected Return on a Portfolio is

computed as the weighted average of the expected returns on the stocks which comprise the

portfolio. The weights reflect the proportion of the portfolio invested in the stocks.

Mean returns attempt to quantify the relationship between the risk of a portfolio of

securities and its return. It assumes that while investors have different risk tolerances, rational

investors will always seek the maximum rate of return for every level of acceptable risk. It is the

mean, or expected, return that investors try to maximize at each level of risk.

ܧݔ݁ܿݐܴ݁݀݁ݐݑݎ݊ ൌ

ܥܽ݅ݐ݈ܽܩܽ݅݊ ܦ݅ݒ݅݀݁݊݀ܩܽ݅݊

ܲݎ݁ݒ݅ݑݏܯܽݎ݇݁ݐܲݎ݅ܿ݁

ܧݔ݁ܿݐܴ݁݀݁ݐݑݎ݊ ൌ

ሺܥݑݎݎ݁݊ݐܯܽݎ݇݁ݐܲݎ݅ܿ݁ െ ܲݎ݁ݒ݅ݑݏܯܽݎ݇݁ݐܲݎ݅ܿ݁ሻ ܦ݅ݒ݅݀݁݊݀ܩܽ݅݊

ܲݎ݁ݒ݅ݑݏܯܽݎ݇݁ݐܲݎ݅ܿ݁

Variance of a stock:- Variance measures the variability (volatility) from an average. Volatility is a

measure of risk, so this statistic can help determine the risk an investor might take on when

purchasing a specific security. Variance is a mathematical expectation of the average squared

deviations from the mean.

Mathematically:- Let the return on a security for n periods be given by R

i

where i = 1 to n then

ܧݔ݁ܿݐܴ݁݀݁ݐݑݎ݊ሺܴ

ത

ሻ ൌ

σ ܴ

ୀଵ

݊

Corporate Finance Section-F, Group-6

IMT Ghaziabad Page 4

and

ܸܽݎ݅ܽ݊ܿ݁ሺߪ

ଶ

ሻ ൌ

σ ሺܴ

െܴ

ത

ሻ

ଶ

ୀଵ

݊

The deviation ሺܴ

െܴ

ത

ሻ indicates the dispersion of returns͛, some dispersion may be

negative while others may be positive to nullify their effect we use the squared deviations.

Standard Deviation of the stock:- Standard deviation is applied to the annual rate of

return of an investment to measure the investment's volatility

For example, a volatile stock will have a high standard deviation while the deviation of a stable

blue chip stock will be lower. A large dispersion tells us how much the return on the fund is

deviating from the expected normal return. Mathematically, Standard deviation is the square

root of the variance..

ߪ ൌ ܵܦሺܴሻ ൌ ඥܸܽݎሺܴሻ

Covariance between two stocks:-

Covariance is a measure of the degree to which returns on two risky assets move in tandem. A

positive covariance means that asset returns move together. A negative covariance means

returns move inversely. One method of calculating covariance is by looking at return surprises

(deviations from expected return) in each scenario. Another method is to multiply the

correlation between the two variables by the standard deviation of each variable.

For example, if stock A's return is high whenever stock B's return is high and the same can be

said for low returns, then these stocks are said to have a positive covariance. If an investor

wants a portfolio whose assets have diversified earnings, he or she should pick financial assets

that have low covariance to each other. Mathematically,

ߪ

ൌ ܥݒሺܴ

ǡ ܴ

ሻ ൌ

σሺܴ

െܴ

തതത

ሻ כ ሺܴ

െܴ

തതതത

ሻ

݊

Corporate Finance Section-F, Group-6

IMT Ghaziabad Page 5

Correlation between stocks:-

Correlation between two stocks is used as a statistical measure of how two securities move in

relation to each other. Correlation is computed into what is known as the correlation

coefficient, which ranges between -1 and +1. Perfect positive correlation (a correlation co-

efficient of +1) implies that as one security moves, either up or down, the other security will

move in lockstep, in the same direction. Alternatively, perfect negative correlation means that

if one security moves in either direction the security that is perfectly negatively correlated will

move in the opposite direction. If the correlation is 0, the movements of the securities are said

to have no correlation; they are completely random. Mathematically,

ߩ

ൌ ܥݎݎሺܴ

ǡ ܴ

ሻ ൌ

ܥݒሺܴ

ǡ ܴ

ሻ

ߪ

כ ߪ

Portfolio of stocks:-

A grouping of financial assets such as stocks, bonds and cash equivalents, as well as their

mutual, exchange-traded and closed-fund counterparts. Prudence suggests that investors

should construct an investment portfolio in accordance with risk tolerance and investing

objectives.

For example, a conservative or a risk-averse investor might favour a portfolio with large cap

value stocks, broad-based market index funds, investment-grade bonds and a position in liquid,

high-grade cash equivalents. In contrast, a risk loving investor might add some small cap growth

stocks to an aggressive, large cap growth stock position, assume some high-yield bond

exposure, and look to real estate, international and alternative investment opportunities for his

or her portfolio.

Expected returns on a portfolio:-

The average of a probability distribution of possible returns, calculated by using the following

formula:

ܧݔ݁ܿݐܴ݁݀݁ݐݑݎ݊ሺܴ

ത

ሻ ൌ ܺ

כ ܴ

Where, X

i

is the weight of Stock i, with a return R

i.

For example, if a given investment had a 50% chance of earning a 10% return, a 25% chance of

earning 20% and a 25% chance of earning -10%, the expected return would be equal to 7.5% =

(0.5) (0.1) + (0.25) (0.2) + (0.25) (-0.1) = 0.075 = 7.5%

Corporate Finance Section-F, Group-6

IMT Ghaziabad Page 6

Although this is what one expects the return to be, there is no guarantee that it will be the

actual return.

Variance of a portfolio:-

The measurement of how the actual returns of a group of securities making up a portfolio

fluctuate. Portfolio variance looks at the standard deviation of each security in the portfolio as

well as how those individual securities correlate with the others in the portfolio. Generally, the

lower the correlation between securities in a portfolio, the lower the portfolio variance.

Portfolio variance is calculated by multiplying the squared weight of each security by its

corresponding variance and adding two times the weighted average weight multiplied by the

covariance of all individual security pairs. Modern portfolio theory says that portfolio variance

can be reduced by choosing asset classes with a low or negative correlation, such as stocks and

bonds. This type of diversification is used to reduce risk.

Mathematically;

ܸܽݎሺܲݎݐ݂݈݅ሻ ൌ ܺ

ଶ

ߪ

ଶ

ʹܺ

ܺ

ߪ

ܺ

ଶ

ߪ

ଶ

Also,

ܸܽݎሺܲݎݐ݂݈݅ሻ ൌ ܺ

ଶ

ߪ

ଶ

ʹܺ

ܺ

ߩ

ߪ

ߪ

ܺ

ଶ

ߪ

ଶ

Standard Deviation of a portfolio:-

The Standard deviation of a portfolio is given by the following formula:

ܵܦሺܲݎݐ݂݈݅ሻ ൌ ඥܸܽݎሺܲݎݐ݂݈݅ሻ

The standard deviation of a portfolio͛s return is equal to the weighted average of the standard

deviations of the individual returns whenߩ ൌ ͳ. As long as ߩ ൏ ͳ, the standard deviation of a

portfolio of securities is less than the weighted average of the individual securities, i.e. the

diversification effect applies as long as there is less than perfect correlation between the

securities.

Corporate Finance Section-F, Group-6

IMT Ghaziabad Page 7

Portfolio

Overview

The Expected return for the individual stocks can also be tabulated as follows:

Company Expected returns in %

HCL 36.78

IOCL -6.32

PNB 31.63

EMAMI 19.16

Variance and Covariance of the four securities can be tabulated as follows:

HCL

Technologies

IOCL PNB EMAMI

HCL

Technologies

9824.211

כ ܺ

ு

ଶ

-1184.582כ

ܺ

ு

כ ܺ

ூை

5708.158

ܺ

ு

כ ܺ

ே

6722.993

ܺ

ு

כ ܺ

ாெெூ

IOCL -1184.582כ

ܺ

ு

כ ܺ

ூை

278.819

ܺ

ூை

ଶ

-598.035

ܺ

ே

כ ܺ

ூை

-711.326

ܺ

ூை

כ ܺ

ாெெூ

PNB 5708.158

ܺ

ு

כ ܺ

ே

-598.035

ܺ

ே

כ ܺ

ூை

3496.181

ܺ

ே

ଶ

4355.081

ܺ

ே

כ ܺ

ாெெூ

EMAMI 6722.993

ܺ

ு

כ ܺ

ாெெூ

-711.326

ܺ

ூை

כ ܺ

ாெெூ

4355.081

ܺ

ே

כ ܺ

ாெெூ

7971.142

ܺ

ாெெூ

ଶ

Calculations:-

Expected Returns

The expected return for the portfolio can now be given by:

Expecteuetuinሺitfሻ ൌ ͲǤ͵ כ ܺ

ு

െͲǤͲ כ ܺ

ூை

ͲǤ͵ʹ כ ܺ

ே

ͲǤͳͻ כ ܺ

ாெெூ

Let there be a weight of 0.25 assigned to all the four securities then the expected return will

be given by:-

Expecteuetuinሺitfሻ ൌ ͲǤ͵ כ ͲǤʹͷ െͲǤͲ כ ͲǤʹͷ ͲǤ͵ʹ כ ͲǤʹͷ ͲǤͳͻ כ ͲǤʹͷ

Expecteuetuinሺitfሻ = .205 or 20.5%

Corporate Finance Section-F, Group-6

IMT Ghaziabad Page 8

Efficient Frontier:-

Efficient Frontier:- The hyperbola is sometimes referred to as the 'Markowitz Bullet', and is the

efficient frontier if no risk-free asset is available. With a risk-free asset, the straight line is the

efficient frontier.

A portfolio lying on the efficient frontier represents the combination offering the best possible

expected return for given risk level.

Interpretation: - By using the obtained frontier we can find out the ͞efficient frontier͟. This

will help in obtaining the optimal portfolios for different risk-averse and risk-taking investors.

We can also figure out the minimum variance portfolio and corresponding weightage and its

returns.

Corporate Finance Section-F, Group-6

IMT Ghaziabad Page 9

References:

Reference Text:

Corporate Finance (8

th

Edition) by Ross, Westerfield, Jaffe and Kakani

Online Resources:

y www.moneycotrol.com

y www.investopedia.com

y www.bseindia.com

y www.wikipedia.com

125 million) and profit of Rs.005 crore. and offers integrated portfolio of services including software-led IT solutions. underlined by innovation and value creation. EMAMI Ltd. ranked at the 98th position. 3. variance and standard deviations along with the covariance between them and thus plot the efficient frontier for the portfolio. R S Goenka since 1974. Indian Oil s vision is driven by a group of dynamic leaders who have made it a name to reckon with. Companies at a glance: 1. paper . Punjab National Bank (BSE :532461 l PNB ) 4. IMT Ghaziabad Page 2 . hospitals.Since its humble beginning in 1895 with the distinction of being the first Swadeshi Bank to have been started with Indian capital. Group-6 Objective:To track a multi-share portfolio consisting of four stocks traded on the open market: 1.000 passionate and dedicated staff.28. Punjab National Bank:. Indian Oil is the highest ranked Indian company in the latest Fortune Global 500 listings. With an aggregate group turnover of about Rs 3700 crore the group has business interests in FMCG (fast moving consumer goods). The Group s fountain of strength are its ingrained value system. Indian Oil Corporation limited:. 7445 crore ($ 1. cement. is India's largest company by sales with a turnover of Rs. HCL Technologies (BSE: 532281 | HCLTECH) 2. pharmacy. working with clients in the areas that impact and redefine the core of their businesses. contemporary art. remote infrastructure management.55. PNB has achieved significant growth in business which at the end of March 2011 amounted to Rs 5. Since its inception into the global landscape after its IPO in 1999. R S Agarwal and Mr.633 million) for the year 2010-11. Indian Oil Corporation Limited ((BSE: 530965 l IOCL) 3. innovativeness and an over 20. a conglomerate born out of Bengal has a pan India presence through its battery of brands and business initiatives that blossomed under the parentage of Mr. writing instruments. 3. 4. 2. engineering and R&D services and BPO.Corporate Finance Section-F. PNB is ranked as the 2nd largest bank in the country after SBI in terms of branch network. HCL focuses on 'transformational outsourcing'. engaged in knowledge sharing.Indian Oil Corporation Ltd. bio-diesel. real estate and retail. (BSE:531162 l EMAMI LTD) And chart their five year-by-year returns. edible oil and cultivation. HCL Technologies is a leading global IT services company. Emami Group. calculate the returns. business and many other parameters.744 crore ($ 72.

Returns: . It is the mean. It assumes that while investors have different risk tolerances. Mathematically:. or expected. The Expected Return on a Portfolio is computed as the weighted average of the expected returns on the stocks which comprise the portfolio. beauty and personal care products that are based entirely on ayurvedic formulation. The weights reflect the proportion of the portfolio invested in the stocks. rational investors will always seek the maximum rate of return for every level of acceptable risk. a leading player in the personal and healthcare consumer products industry in India engaged in manufacturing and marketing of health.Corporate Finance Section-F. return that investors try to maximize at each level of risk. Variance is a mathematical expectation of the average squared deviations from the mean. The focus is on providing the consumers with innovative products which are capable of meeting their multiple needs and add value by enhancing the quality of day-to-day life. is a coveted Rs 1300 crore business entity .Let the return on a security for n periods be given by Ri where i = 1 to n then IMT Ghaziabad Page 3 . Variance of a stock:. Mean returns attempt to quantify the relationship between the risk of a portfolio of securities and its return. so this statistic can help determine the risk an investor might take on when purchasing a specific security.Variance measures the variability (volatility) from an average. Group-6 Emami Limited.Return is the ratio of money gained or lost (whether realized or unrealized) on an investment relative to the amount of money invested. Volatility is a measure of risk. the flagship company of the Group. Emami Limited has over 30 brands under its portfolio.

Standard deviation is the square root of the variance.Standard deviation is applied to the annual rate of return of an investment to measure the investment's volatility For example.. Mathematically. Group-6 and The deviation indicates the dispersion of returns . Covariance between two stocks:Covariance is a measure of the degree to which returns on two risky assets move in tandem. Standard Deviation of the stock:. A negative covariance means returns move inversely. One method of calculating covariance is by looking at return surprises (deviations from expected return) in each scenario. A large dispersion tells us how much the return on the fund is deviating from the expected normal return. some dispersion may be negative while others may be positive to nullify their effect we use the squared deviations. then these stocks are said to have a positive covariance. a volatile stock will have a high standard deviation while the deviation of a stable blue chip stock will be lower. For example. Another method is to multiply the correlation between the two variables by the standard deviation of each variable. he or she should pick financial assets that have low covariance to each other. if stock A's return is high whenever stock B's return is high and the same can be said for low returns.Corporate Finance Section-F. Mathematically. IMT Ghaziabad Page 4 . A positive covariance means that asset returns move together. If an investor wants a portfolio whose assets have diversified earnings.

and look to real estate. perfect negative correlation means that if one security moves in either direction the security that is perfectly negatively correlated will move in the opposite direction.1) + (0. high-grade cash equivalents. they are completely random.075 = 7.25) (0. In contrast. Portfolio of stocks:A grouping of financial assets such as stocks.5% IMT Ghaziabad Page 5 . as well as their mutual. Expected returns on a portfolio:The average of a probability distribution of possible returns. broad-based market index funds. Perfect positive correlation (a correlation coefficient of +1) implies that as one security moves.5) (0. the other security will move in lockstep. international and alternative investment opportunities for his or her portfolio.2) + (0. a conservative or a risk-averse investor might favour a portfolio with large cap value stocks. Alternatively.Corporate Finance Section-F. exchange-traded and closed-fund counterparts. a risk loving investor might add some small cap growth stocks to an aggressive. with a return Ri. which ranges between -1 and +1. if a given investment had a 50% chance of earning a 10% return. Group-6 Correlation between stocks:Correlation between two stocks is used as a statistical measure of how two securities move in relation to each other. in the same direction. large cap growth stock position. either up or down. For example. Correlation is computed into what is known as the correlation coefficient. Xi is the weight of Stock i. If the correlation is 0. Prudence suggests that investors should construct an investment portfolio in accordance with risk tolerance and investing objectives. investment-grade bonds and a position in liquid. a 25% chance of earning 20% and a 25% chance of earning -10%. For example. bonds and cash equivalents.25) (-0. Mathematically. the movements of the securities are said to have no correlation. calculated by using the following formula: Where. the expected return would be equal to 7.1) = 0. assume some high-yield bond exposure.5% = (0.

Portfolio variance looks at the standard deviation of each security in the portfolio as well as how those individual securities correlate with the others in the portfolio. Also. This type of diversification is used to reduce risk. IMT Ghaziabad Page 6 . such as stocks and bonds. Portfolio variance is calculated by multiplying the squared weight of each security by its corresponding variance and adding two times the weighted average weight multiplied by the covariance of all individual security pairs. As long as . Modern portfolio theory says that portfolio variance can be reduced by choosing asset classes with a low or negative correlation. the lower the correlation between securities in a portfolio.Corporate Finance Section-F. Group-6 Although this is what one expects the return to be.e. Standard Deviation of a portfolio:The Standard deviation of a portfolio is given by the following formula: The standard deviation of a portfolio s return is equal to the weighted average of the standard deviations of the individual returns when . the lower the portfolio variance. there is no guarantee that it will be the actual return. the standard deviation of a portfolio of securities is less than the weighted average of the individual securities. i. the diversification effect applies as long as there is less than perfect correlation between the securities. Mathematically. Variance of a portfolio:The measurement of how the actual returns of a group of securities making up a portfolio fluctuate. Generally.

158 6722.035 5708.993 3496.211 -1184.16 Variance and Covariance of the four securities can be tabulated as follows: HCL Technologies 9824.63 19.5% IMT Ghaziabad Page 7 .142 Calculations:Expected Returns The expected return for the portfolio can now be given by: Let there be a weight of 0.081 HCL Technologies IOCL PNB EMAMI 278.326 4355.181 4355.32 31.205 or 20.081 -711.78 -6.158 -598.25 assigned to all the four securities then the expected return will be given by: = .819 -598.326 7971. Group-6 Portfolio Overview The Expected return for the individual stocks can also be tabulated as follows: Company HCL IOCL PNB EMAMI Expected returns in % 36.993 -711.582 PNB 5708.Corporate Finance Section-F.035 EMAMI 6722.582 IOCL -1184.

and is the efficient frontier if no risk-free asset is available.Corporate Finance Section-F.By using the obtained frontier we can find out the efficient frontier . With a risk-free asset.The hyperbola is sometimes referred to as the 'Markowitz Bullet'. We can also figure out the minimum variance portfolio and corresponding weightage and its returns. Interpretation: . A portfolio lying on the efficient frontier represents the combination offering the best possible expected return for given risk level. IMT Ghaziabad Page 8 . This will help in obtaining the optimal portfolios for different risk-averse and risk-taking investors. the straight line is the efficient frontier. Group-6 Efficient Frontier:- Efficient Frontier:.

com www. Group-6 References: Reference Text: Corporate Finance (8th Edition) by Ross.Corporate Finance Section-F.com www. Westerfield.com www. Jaffe and Kakani Online Resources: y y y y www.bseindia.wikipedia.investopedia.moneycotrol.com IMT Ghaziabad Page 9 .

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