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Modern portfolio theory

MPT postulates that savers are generally risk averse and try to reduce risk by all possible methods The markets are perfect and absorb all information perfectly and returns are the same whenever you enter the market The principle of dominance is applied to select a portfolio on the frontier line

Basis of modern portfolio theory The tripod on which this theory depends are: A Diversification Investment in more than one security ,asset ,industry etc with a view to reduce risks B CAPM theory and concept of Dominance C Role of beta it is a measure of sensitivity of the return of one asset to the market return

Modern portfolio theory postulates the following axioms 1. Diversification reduces the total risk but applicable only to co specific unsystematic risk 2. CAPM states that where shares are correctly priced every security is expected to earn returns commensurate with the risk it carries 3. The riskiness of a security is to be seen in the context of portfolio or market related risk ,but not in isolation 4. The importance of Beta is for managing non diversifiable part of the risk

Asset allocation decision

Investors data base is the starting point for designing an investment strategy Factors for investment strategy: Need for regular income Regularity - monthly or yearly Need for cash inflow to meet the liabilities Asset liability mix or inflow outflow pattern Need for capital appreciation or a mixture of both income and capital appreciation

Investors objective can be set of as: Income Growth Both

The following major asset classes are used for in the portfolios A) Equities (variable income instruments) B) Debenturess,Bonds (Fixed income instruments) C)Cash and money market instruments (Short duration instruments)

Every investor should allocate towards cash outfows in the form of: administrative expenses Salaries Wages Stationery Incidental expenses

5 to 10 % of investment needs to be kept in : Cash Bank deposits Money market instruments

The proportion in equity and debentures would depend upon the specific objective of invetment Income Growth Mixture of both

The traditional theory lays down that diversification as a technique of selection of securities in a portfolio This is called random diversifiaction or simple diversification It is based on a simple rule of two is better than one Simple diversification was found to be more remunerative

Nave diversification or superfluous diversification may result from random and indiscriminate selection of securities ,which does not lead to any reduction of risk Thus an investor may have 10 scrips in steel,mini steel and ferrous metals,which will only increase risk But an investor having 10 scrips spread in cycles,electronics,sugar,steel,auto etc,will have less risk as these industries are not co related and their risks are independent of each other or even negatively related.

Why diversification
It is never prudent to put all ones eggs in one basket,as it may lead to total ruin if the basket itself is broken or lost The human behaviour is normally risk averse

Diversification is a technique of reducing the risk involved in investment and portfolio management It is a process of conscious selection of assets ,instruments and scrips of cos and govt securities ,in a manner that total risks are brought down This process helps in the reduction of risk ,under category of what is known as unsystematic risk and promotes optimisation of returns

Forms of diversification: Types of asets:gold,real estate,govt securities ,corporate securities Instrumentsor security type bonds,debentures stocks Industry lines:plastics ,chemicals ,engineering Companies:new cos,growing cos,new product cos

Principles of diversification: A single co/industry is more risky than two cos/industries Two cos in say,steel industry are more risky than one co in tyre and tubes and one co in steel Two cos or two industries which are similar in nature of demand or market are more risky than the two in dissimilar industry.

Methods of diversification
Randomness of selection of cos and industries: the probability of reducing risk is more with a random selection as the statistical error of choosing wrong cos will come down due to randomness of selection which is a statistical technique Optimisation of selection process Adequate diversification: this involves as many industries and cos as possible to get the best results

Markowitz diversification
He postulated that diversification should not only aim at reducing risk of a security by reducing its variability and standard deviation,but by reducing the co variance or interactive risk of two or more securities The theory attaches importance to standard deviation ,to reduce it to zero and co variance

Assumptions of markowitz theory: Investors are rational and behave in a manner as to maximise their utility with a given level og income or money Investors have free access to fair and correct information The markets are efficient and absorb information quickly Investors are risk averse and try to maximise risk and return Investors prefer higher returns to lower return for a given level of risk

Guidelines for diversification diversification involve s a proper no of securities ,not too few or many which have no co relation To build up a efficient port folio the following parameters are to be seen 1. expected return 2.variability of returns as measured by standard deviation from the mean variance or variance of one asset return to another asset returns. The higher the expected return ,lower the standard deviation ,lower the correlation ,the better will be the security for investment .

Whatever is the risk of the individual securities in isolation ,the total risk of portfolio of securities may be lower,if the covariance of their returns is negative or negligible

Dominant and efficient portfolio

Dominance refers to the superiority of one portfolio over the other A set can dominate over the other,if with the same return ,the risk is lower or with the same risk,the return is higher Dominance principle involves the trade off between risk and return

The concept of dominance tells that no investor should invest in one co alone and if there are two or more cos with the same risk ,then he has to choose the one with higher returns and if both have the sane return he has to choose the one with lower risk

A portfolio is efficient when it is expected to yield the highest return for the level of risk accepted or,alternatively ,the smallest possible risk for a specified level of expected return To build an efficient portfolio an expected return level is chosen ,and assets are substituted until the portfolio combination with the small variance at the return level is found As this process is repeated for other expected returns,a setof efficient portfolios is generated. A single asset or portfolio is efficient if no other asset or portfolio offers higher expected return with the same or lower risk or lower risk with the same expected return

Efficient frontier Expected return

Standard deviation

Corner portfolios
The number of portfolios on the efficiency frontier are called corner portfolios A corner portfolio is defined as one in which either The new security is added to a previously efficient portfolio A security is dropped from a previousy efficient portfolio.

Limitations of markowitz It related each security to every other security demanding the sophistication and volume of work beyond the capacity of all

Sharpe model
Sharpe model relates their return in a security to a single market index This will reflect all well traded securities in the market It will reduce and simplify the work involved in compiling elaborate matrices of variances as between individual securities

The optimal portfolio of sharpe is called the single index model The optimum portfolio is directly related to the beta

Calculate the co variance and coefficient of variance from the following data stocks are X and Y and their returns are given below return expected return X 14 18 Y 26 18 X 22 18 Y 10 18

X Y dx dy d^2x d^2y 14 26 -4 8 16 64 22 10 4 -8 16 64 ----- ------- --- 36 36 32 128 SD X= 32/2=4 SD Y = 128/2=8

CO VARIANCE CV=1/2(14-18)(26-18)+1/2(22-18)(10-18 =1/2(-4 x +8)+1/2(4 x -8) =1/2(-32)+1/2(-32) =-16 -16 =-32

Coefficient of correlation =Cov XY ----------x y = -32 ----------4 x 8 = -32/32 = -1 Correlation coefficient is negative and they are perfectly negatively correlated

Calculate the co variance and coefficient of variance from the following data stocks are X and Y and their returns are given below return expected return X 7 9 Y 13 9 X 11 9 Y 5 9

X Y dx 7 13 -2 11 5 2 ----- --- 18 18 SD X= 16/2=2 SD Y = 32/2=4

dy d^2x d^2y 4 4 16 -4 4 16 ---- ---16 32

CO VARIANCE CV=1/2(7-9)(13-9)+1/2(11-9)(5-9) = -8

Coefficient of correlation =Cov XY ----------x y = -8 ----------2 x 4 = -8/8 = -1 Correlation coefficient is negative and they are perfectly negatively correlated

Portfolio management process

Planning Investor conditions Market conditions Investment /speculative policies Statement of investment policy Strategic asset allocation

Investor conditions Financial situation marketable non marketable Knowledge Risk tolerance

Market conditions Long term expectations Short term expectations

Investors policy 1. Strategic asset allocation- current & passive rebalancing 2. Speculative strategy tactical asset allocation 3. Internal and external management

1. 2. 3.

Statement of investment policy Objectives Strategies constraints

Implementation Rebalance strategic asset allocation Tactical asset allocation Security selection

Monitoring Evaluate statement of investment policy Evaluate investment performance

Statement of investment policy 1.Compliance 2. Periodic revision Portfolio performance: Aggregate portfolio Asset classes and managers Speculative strategy returns

Actions required control: Statement of investment policy Manager selection

Investment policy Security analysis Valuation of securities Portfolio construction Portfolio evaluation

Phases of portfolio management 1. Specification of investment objectives and constraints 2. Choice of asset mix 3. Formulations of investment strategy 4. Portfolio execution 5. Portfolio revision 6. Portfolio evaluation

International diversification
Many in developed countries started investing in foreign bonds , stocks and other instruments Diversification was extended to foreign assets to improve returns for a given risk by adopting proper techniques of diversifiocation

Higher returns Wide area of opportunities and investment avenues different business conditions and trends