So far

Module 4 : Investment
Avenues
Mutual funds, Investor life cycle, Personal
investment, Personal Finance, Portfolio Management
of funds in banks, insurance companies, pension
funds, International investing, international funds
management, emerging opportunities.
Module 1: Introduction to portfolio
Management
Meaning of portfolio management, portfolio
analysis, why portfolios, Portfolio objectives,
portfolio management process, selection of
securities.
Portfolio
theory
Module II

Mohammed Umair: Dept of Commerce- Kristu

Jayanti College
Exercise

Company High Low Previous

Name (LTP)
Hero Motocorp 2600 2400 2500

HDFC Bank 520 499 500

State Bank of India 2100 2029 2000
TCS 1020 998 1000
Tech Mahindra 108 105 100

Budget: Rs. 5000

Exercise

Company High Low Previous

Name (LTP)
Hero Motocorp 2600 2400 2600

HDFC Bank 520 499 550

State Bank of India 2100 2029 2000
TCS 1020 998 1050
Tech Mahindra 108 105 150

Situation A: Bullish Market

Exercise

Company High Low Previous

Name (LTP)
Hero Motocorp 2600 2400 2200

HDFC Bank 520 499 300

State Bank of India 2100 2029 1750
TCS 1020 998 850
Tech Mahindra 108 105 050

Situation B: Bearish Market

Phases of Portfolio
Management

Portfolio
Management

Portfolio Portfolio
Security Portfolio Portfolio
Selectio Evaluati
Analysis Analysis Revision
n on
1.
1. Fundamen Diversificat 1. Markow Formula 1. Sharpes
tal ion
Analysis itz Plans index
2. Technical Model 2. Treynor
2. Rupee
Analysis 2. Sharpe s
3. Efficient s Single
cost measure
Market index Averagin 3. Jensons
Hypothesis model g measure
3. CAPM
4. APT
 Harry Markowitz Model
Harry Max Markowitz (born August 24, 1927)
is an American economist.
He is best known for his pioneering work in
Modern Portfolio Theory.
Harry Markowitz put forward this model in
1952.
Studied the effects of asset risk, return,
correlation and diversification on probable Harry Max Markowitz
investment portfolio returns.
Essence of Markowitz Model

Do not put all your eggs in

1. one basket
An investor has a certain amount of capital he wants to invest over a
single time horizon.
2. He can choose between different investment instruments, like stocks,
bonds, options, currency, or portfolio. The investment decision depends
on the future risk and return.
3. The decision also depends on if he or she wants to either maximize the
Essence of Markowitz Model
1. Markowitz model assists in the selection of the most efficient by
analysing various possible portfolios of the given securities.
2. By choosing securities that do not 'move' exactly together, the HM
model shows investors how to reduce their risk.
3. The HM model is also called Mean-Variance Model due to the fact
that it is based on expected returns (mean) and the standard
deviation (variance) of the various portfolios.

Diversification and Portfolio Risk

p p the standard deviation

SR: Systematic Risk

Portfolio Risk

USR: Unsystematic Risk

S
R
USR Total
Risk
5 10 1 20
5
Number of Shares
Assumptions
An investor has a certain amount of capital he
wants to invest over a single time horizon.
He can choose between different investment
instruments, like stocks, bonds, options, currency,
or portfolio.
The investment decision depends on the future
risk and return.
The decision also depends on if he or she wants to
either maximize the yield or minimize the risk.
The investor is only willing to accept a higher risk
if he or she gets a higher expected return.
Tools for selection of portfolio- Markowitz Model
1. Expected return (Mean)
Mean and average to refer to the sum of all values
divided by the total number of values.
The mean is the usual average, so:
(13 + 18 + 13 + 14 + 13 + 16 + 14 + 21 + 13)
9 = 15 n 1. Expected return (Mean)

Expected Return (ER) Wi E ( Ri )

2. Standard deviation
(variance)
3. Co-efficient of Correlation
Where: i 1
ER = the expected return on Portfolio
E(Ri) = the estimated return in scenario i
Wi= weight of security i occurring in the port folio

Rp=R1W1+R2W2
Where: Rp = the expected return on Portfolio
..n R1 = the estimated return in Security 1
R2 = the estimated return in Security 1
W1= Proportion of security 1 occurring in the port
folio
Tools for selection of portfolio- Markowitz Model
2. Variance & Co-variance
n _ _
Variance Prob i ( R A RA ) 2 (R B - RB ) 2
i 1

The variance is a measure of how far a set of numbers

is spread out. It is one of several descriptors of a
probability distribution, describing how far the
numbers lie from the mean (expected value).
Co-variance
1. Covariance reflects the degree to which the returns of the two
securities vary or change together.
2. A positive covariance means that the returns of the two securities
move in the same direction.
3. A negative covariance implies that the returns of the two securities
move in opposite direction.

n
1 _ _ _
COVAB
N
Prob ( R
i 1
i A RA )(R B - RB ) =Expected
RA Return on security A
_
=Expected
RB Return on security
CovAB=Covariance between security A
and B
RA=Return on security A
Tools for selection of portfolio- Markowitz Model
3. Co-efficient of Correlation
Covariance & Correlation are conceptually analogous
in the sense that of them reflect the degree of
Variationbetween
1. two isvariables.
The Correlation coefficient simply covariance divided the product of
standard deviations.
2. The correlation coefficient can vary between -1.0 and +1.0

-1.0 0 1.0
Perfectly No Perfectly
negative Correlati Positive
Opposite on Opposite
direction Cov AB direction
rAB

Standard deviation of A
and B security
A B
CovAB=Covariance between security A and B
rAB=Co-efficient correlation between security A and B
 Affect of Perfectly Negatively
Correlated Returns
Elimination of Portfolio Risk
Returns
If returns of A and B are
%
20% perfectly negatively correlated,
a two-asset portfolio made up of
equal parts of Stock A and B
would be riskless. There would
15% be no variability
of the portfolios returns over
time.

10%

Returns on Stock A
Returns on Stock B
5%
Returns on Portfolio

Time 0 1 2
CHAPTER 8 Risk, Return and Portfolio
Theory
 Example of Perfectly Positively
Correlated Returns
No Diversification of Portfolio Risk
Returns
If returns of A and B are
%
20% perfectly positively correlated, a
two-asset portfolio made up of
equal parts of Stock A and B
would be risky. There would be
15% no diversification (reduction of
portfolio risk).

10%
Returns on Stock A
Returns on Stock B
5%
Returns on Portfolio

Time 0 1 2
CHAPTER 8 Risk, Return and Portfolio
Theory
Grouping Individual Assets into Portfolios
The riskiness of a portfolio that is made of different risky
assets is a function of three different factors:
the riskiness of the individual assets that make up the
portfolio
the relative weights of the assets in the portfolio
the degree of variation of returns of the assets making up the
portfolio

measured using the pMarkowitz

w w 2w w r B
The standard deviation of a two-asset
2 2
A model:
A
2portfolio
B B
2 may be
A B AB A

Risk of a Three-Asset
Portfolio
A
The data requirements for a three-asset portfolio grows
dramatically if we are using Markowitz Portfolio selection formulae.
a,b a,c
B C
We need 3 (three) correlation coefficients between A and B; A and
b,c
C; and B and C.

p A2 wA2 B2 wB2 C2 wC2 2wA wB rA, B A B 2wB wC rB ,C B C 2wA wC rA,C A C

Implications for Portfolio
Formation
Assets differ in terms of expected rates of
return, standard deviations, and
correlations with one another
While portfolios give average returns, they give
lower risk
Diversification works!
Even for assets that are positively
correlated, the portfolio standard deviation
tends to fall as assets are added to the
portfolio
Implications for Portfolio
Formation
Combining assets together with low correlations
reduces portfolio risk more
The lower the correlation, the lower the portfolio standard
deviation
Negative correlation reduces portfolio risk greatly
Combining two assets with perfect negative correlation
reduces the portfolio standard deviation to nearly zero
Efficient
frontier n
Expected Return (ER) Wi E ( Ri )

p
i 1

Portfolio Rp IN %Return on Ris Any portfolio which gives

Portfolio k
A 17 13 more return for the same
level of risk.
B 15 08
C 10 03 Or
D 7 02
Same return with Lower
E 7 04
risk.
F 10 12
G 10 12 Is more preferable then
any other portfolio.
H 09 08
J 06 7.5

Amongst all the portfolios which offers

the highest return at a particular level
of risk are called efficient portfolios.
Efficient frontier ABCD line is the efficient frontier along
which attainable and efficient portfolios
18 are available.
Which portfolio investor should
16 choose?

14

13
12
12 12
Risk and

10
Return
Return

Risk
8
8 8
7.5

4
4

3
2
2

0
A B C D E F G H I

Portfolios
Utility analysis with Indifference Curves
Utility of
Investor

Risk Lover Risk Neutral Risk Averse

Description Property
Risk Seeker Accepts a fair Gamble
Risk Neutral Indifferent to a fair
gamble
Risk Averse Rejects a fair gamble

A
B

Marginal utility of Utility

different class of C
investors.

Return
Rp Rp

Indifference curves of Indifference curves of

the risk Loving
I4 the risk IFearing
I3 4
I3
I2 I2
I1 I1

Risk Risk
Rp
Indifference curves of Rp
the less risk Fearing Indifference curves &
I4 Efficient frontier.
I4
I3 I3
I2 I2
I1 I1
R

Risk Risk
2 4 6 8 10 12 14 14 18
Optimal
Portfolio
The optimal portfolio concept falls under the
modern portfolio theory. The theory assumes that
investors fanatically try to minimize risk while
striving for the highest return possible.
 DEFINING THE RISK FREE ASSET
WHAT IS A RISK FREE ASSET?
DEFINITION: an asset whose terminal value is certain
variance of returns = 0,
covariance with other assets = 0

If i 0
then ij ij i j
0
DEFINING THE RISK FREE
ASSET
DOES A RISK FREE ASSET
EXIST?
CONDITIONS FOR EXISTENCE:
Fixed-income security
No possibility of default
No interest-rate risk
no reinvestment risk

24
DEFINING THE RISK FREE
ASSET
DOES A RISK FREE ASSET EXIST?
Given the conditions, what qualifies?
a U.S. Treasury security with a maturity matching the
investors horizon

DOES A RISK FREE ASSET EXIST?

Given the conditions, what qualifies?
a U.S. Treasury security with a maturity matching the
investors horizon
RISK FREE LENDING
ALLOWING FOR RISK FREE LENDING
investor now able to invest in either or both,
a risk free and a risky asset
RISK FREE LENDING
ALLOWING FOR RISK FREE LENDING
the addition expands the feasible set
changes the location of the efficient frontier
assume 5 hypothetical portfolios

27
THE EFFECT OF RISK FREE LENDING ON THE
EFFICIENT SET

INVESTING IN BOTH: RISKFREE AND RISKY ASSET

PORTFOLIOS X1 X2 ri

A .00 1.0 4 0
B .25 .75 7.05 3.02
C .50 .50 10.106.04
D .75 .25 13.159.06
E 1.00 .00 16.20 12.08

28
THE EFFECT OF RISK FREE LENDING ON THE
EFFICIENT SET

RISKY AND RISK FREE PORTFOLIOS

rP E
D
C
B
A
rRF = 4% P
0

29
THE EFFECT OF RISK FREE LENDING ON THE
EFFICIENT SET
IN RISKY AND RISK FREE PORTFOLIOS
All portfolios lie on a straight line
Any combination of the two assets lies on a straight line
connecting the risk free asset and the efficient set of the
risky assets
rP

The Connection to the Risky Portfolio

P
0
THE EFFECT OF RISK FREE LENDING ON THE
EFFICIENT SET

The Connection to the Risky Portfolio

rP
S

P
P
0
31