LAIKIPIA UNIVERSITY

BCOM 433: INVESTMENT AND PORTFOLIO MANAGEMENT

Instructor: Esther Chepkorir Rono
1. Purpose
This course is designed to provide students with skills to apply portfolio
management techniques in selecting and managing their investments for optimal
returns.
2. Course Objectives
By the end of this course the students should be able to:
(a) Identify the processes in setting portfolio investment objectives and selecting
investment.
(b) Understand the modern portfolio theories and techniques.
(c) Select the appropriate portfolio management software in the market.
Course Content
Topic/Lecture Activities/Assignments
1 Investment setting
1.1 Meaning of investment
1.2 Forms of investment
1.3 Key steps in investment management
1.4 Setting of investment objectives
1.5 Investment strategies
1.6 Investment Constraints
2 Real estate
1.1 Real Estate
1.2 Sources of investment capital
1.3 Risk management
1.4 Real estate appraisals
1.5 The primary cause of investment failure
3 Analysis of equity securities
3.1 Valuation
3.2 Valuation Models
3.3 Determination of Expected Return
4 The concept of risk and return
4.1 Measures of risk
4.2 Managing portfolio risk

5 Managing portfolio risk CAT 1

5.1 Specific types of risk
5.2 Asset allocation

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 5.3 Portfolio revision
5.4 Evaluation of portfolio performance
The Sharpe Ratio, The Sharpe’s single-index
model (SIM), Jensen’s Alpha, Treynor ratio, The
Treynor–Black Appraisal Ratio, Treynor–Mazuy
Market Timing Measure, Merton–Henriksson
Market Timing Measure, Multibeta /multi-factor
Models, Weight-Based Performance Measures
6 Efficient Market Hypothesis
6.1 Forms of efficient markets
6.2 Random walk theory
7 Modern portfolio theories and techniques
7.1 Modern Portfolio Theory (MPT)
7.2 Efficient frontier
7.3 Capital market line
7.4 Portfolio weights
8 Computer technology in portfolio management CAT 2
8.1 Front-office transformation through technology
8.2 Computer technology in portfolio management
8.3 Latest technology developments
8.4 IT portfolio management
Teaching methodology
A large part of this course will be conducted through lectures, discussions,
assignments and student led presentations. Normal lectures will be conducted on
some topics. Hence, this course would have a deep application on auditing
concepts.
Instructional materials/equipment
Teaching methods include Lectures, Class presentations and Group discussions.
Course evaluation
Continuous Assessment Tests 30%
University examination 70%
References

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1. INVESTMENT SETTING
1.1 What is an investment
Investment is: ‘the commitment of money for a period of time in order to derive
future receipts that will compensate the investor for the time the funds are
committed, for the expected rate of inflation, and for the uncertainty of the future
flow of income’.
1.2 Forms of investment
A financial asset is a financial claim on an asset that is usually documented by
some form of legal representation e.g. a share of stock or a bond. A real asset is an
actual tangible asset that may be seen, felt, held e.g. real estate or gold. Direct
equity claims represent ownership interests and include common stock as well as
other instruments that can be used to purchase common stock, such as warrants and
options. Indirect equity can be acquired through placing funds in investment
companies (such as a mutual fund). The investment company pools the resources
of many investors and reinvests them in common stock (or other investments).
Creditor claims are debt instruments offered by financial institutions, industrial
corporations, or the government. Preferred stock is a hybrid form of security
combining some of the elements of equity ownership and creditor claims, and
Commodity futures is a contract to buy or sell a commodity, e.g. wheat, copper or
such financial instruments as Treasury bonds in the future at a given price.
1.3 The key steps involved in portfolio investment management process
Project Portfolio Management is the continuous process of selecting and managing
the optimum set of project-oriented initiatives that deliver the maximum in
business value or return on investment.
1.3.1 A Portfolio Management Process
The Inventory Phase, is an exercise to define an inventory of projects and gather
project and organizational data to support the second phase, Analysis. This phase
is an exercise in summarizing and reviewing the data and selecting projects. The
third phase, Alignment, is an exercise in establishing metrics, modeling and
balancing the portfolio. Manage is an exercise in mobilizing and managing the
portfolio- performing project scheduling, accounting and collaboration.
i) The Portfolio Inventory Stage
- Identify Strategic Objectives
- Identify all projects and organizational structure, resource data, budgets,
project attributes and priorities
- Categorize projects
- Identify gating process
- Map projects to strategic goals

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This phase begins by capturing all projects under way and gathering key project
and organizational information. Most organizations know large project initiatives
that are under way, but no record of the mid-size to small project initiatives. An
effective portfolio management process can be done without having 100% of the
projects into the system.
To know if you have gathered enough project information, input projects into a
system with basic project data (this could be as simple as an Excel spreadsheet).
The basic project data should include at a minimum; project name, descriptions,
total assigned full time equivalent (FTE's), dollars spent to date and anticipated
total spending. If it has reached 80% this tracking should stop otherwise the
portfolio will be “out of control.” A portfolio can become “out of control” if there
is a vast amount of resources committed to very small and enhancement projects.
Individually it makes no sense to track these in the project portfolio.
Key project data to be collected
The data collected during the inventory phase falls into two classifications, Project
data and Organizational data. Data collected during this phase is at the highest
level possible and is focused strictly on those pieces of information that will be
used in the later Analysis, Alignment and Management phases of this process.
Project details
Gather all project details and attributes; Project Name, Project Code or Project
Identification characteristics, Project Manager, very brief description, major
milestones, current status, resource assignments at the project level of percentage
utilized and projections of resource availability.
Define cost elements
 Identifying current and planned project costs to provide a hierarchy of
cost elements. Typically, the highest levels of the cost elements
hierarchy are labor, material, and other direct costs.
 Identify how actual costs are captured—by project, by task, by
department, by resource?
 Identify how often actual costs are captured—daily, weekly, monthly.
 Define what type of cost units are captured—hours, dollars, labor,
material, equipment, etc.
 Define actual costs compared to budgeted costs—by project, by
organization, by resource.
Define business value
 Prioritize each project by its business value of High, Medium, or Low.
 Identify each project’s relative value as it relates to other projects in
the organization using the recommended Five Point Scale; 0 1 2 3 4 5

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  Identify the economic value or dollar value of each project's total
expected business benefit upon completion.
Define strategic alignment
 Create a list of Strategic Objectives of Goals that contains all your
organizations or company's major business goals. Assign a single
business goal with which the project is most closely aligned.
 Identify the Sponsoring Organization e.g. the executive sponsor's
department.
Identify project and management reporting requirements
 Identify what are your project reporting requirements.
 Determine whether project planning information need to be
summarized at all levels of the organization.
 Define what is the reporting frequency? Weekly, Monthly?
Organizational data
During the analysis phase of this process, time is spent in analyzing resources.
What type of skills do people in the organization have, how many people have
those skills, what projects are they assigned to and what projects don't have enough
of the right people. There is need to assemble a resource pool data.
Resource pool
The key resource data collected should include:
• Resource Name
• Resource Primary Organization
• Primary Skill
• Financial Rate (It is suggested to use a fully burdened standard rate as a best
practice so there might only be a few rates to chose from).
Charge back codes
A best practice is establishing at least a memo charge back system. While this is in
no way required as an initial step, collecting the data on which department or line
of business is requesting the project provides very useful information during the
analysis phase.
ii) The Portfolio Analysis Stage
- Establish metrics
- Summarize project schedule, cost, budget and resource data
- Organize by business units, objectives, values, etc.
- Classify, weight and organize projects
- Finalize gating process
The Analyze Phase assesses the current strengths and weaknesses of the Project
Portfolio.

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There are many kinds of analysis that can be done simply by scanning the
Inventory data now that it is available and accessible in one place. For example:
 A simple sort by project justification may reveal multiple projects that
are attempting to solve the same or similar problems. These projects
might be more efficient if they were combined, or perhaps some of
them should be cancelled.
 A sort by resource category may reveal future shortfalls early enough
to allow thorough consideration of the options: increased headcount,
use of contractors, or cancellation of some projects.
 A sort by user department may show that customer service is soon to
be overwhelmed by the simultaneous release of three new application
systems.
More sophisticated tools can be used to illustrate the degree of alignment between
the current inventory and the organization's strategic priorities. For example,
bubble charts can provide graphical views of:
 How do you align your technology with your business
 The resources that are committed to each major strategic initiative.
 The overall risk of the project portfolio as a whole by comparing the
probability of technical success against the anticipated benefit from
the project.
Once the analysis is completed, executives and managers can view the portfolio in
a wide variety of dimensions. A clear understanding of the entire project portfolio
model will then be presented.
The types of alignment analysis that can be performed during this phase are:
• Are the critical resources working on the critical projects?
• Are their projects aligned with all the strategic initiatives the company wants to
undertake?
Performance
Analyzing the project portfolio is understanding what, on the long list of things
desired, is actually possible to achieve.
Achieving resource capacity
Success in this area is depends on having the right resources available to do the
work. Obvious resource shortfalls identified during the inventory phase are
analyzed to determine possible courses of action. Possible types of analysis can be:
 Evaluating projects with shortfalls to see what project phase they're
currently in. (If two projects have an impending requirement and are
in early phases, it might be possible to consider whether or not they
can be postponed until existing resources free up or whether or not
they're so critical they require resources off another project).

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  Determining long-term courses of action. In the short-term resources
might have to be moved, or contractors hired, but in the long-term,
additional resources can be trained or new people with the right skills
can be hired.
Dependencies and conflicts
From a portfolio project perspective, project dependencies show the inter relation
from one project to another. When you are evaluating any given project analyze
what dependencies are on other projects and what projects are dependent upon it.
This puts an emphasis on project performance even more then project value.
Achieving balance
Strategic Fit—The portfolio should be reviewed to determine the degree of
strategic fit—there should be a balance between near-term growth opportunities,
the need for long-term technology-renewal goals, and the drive for developing long
term innovation.
Strategic Alignment—Once projects are aligned to a strategic goal, the next factor
to look at is the number and nature of these projects. Many companies have
repeatedly found when they reviewed their portfolio; the distribution of projects
aligned to different strategic goals didn't make economic sense. They would never
have realized this fact if they hadn't looked at it from a project portfolio
perspective.
Probability of Success—This analysis refers to the probability that the end
product will deliver the business value (return) expected. It tends to be highly
subjective. One possibility would be to perform a forced ranking within a number
of categories, such as alignment, value, risk, etc. Projects receiving composite low
scores would be given low probability of success values.
Risks
The types of risks analyzed at the portfolio level are not the specific detailed risks
evaluated at the project level. A list of portfolio risks that may be evaluated are:
• Financial Risk
• Schedule Risk
• Technology Risk
• Scope or Deliverable Risk
• Resources Risks (availability or quality).
Scoring model
This is a form of analysis where decision-makers rate the project on a number of
questions that distinguish superior projects, typically on 1–5 or 0–10 scales. These
ratings are added to yield a quantified Project Attractiveness Score, which must
clear a minimum hurdle. This Score is a proxy for the “value of the project to the
company,” but incorporates strategic, leverage and other considerations beyond
just the financial measures.
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Benefits from the analysis phase
The key benefits of the Analysis Phase all center around having gained “a
thorough understanding of what the problems really are and what the future
solutions might be.” The Alignment Phase centers around making the best
decisions about what to do in the immediate term. The analysis phase provides the
data on which to base those decisions. When the analysis phase is completed, the
hard decisions required in the Alignment Phase can be done with more assurance.
iii) The Portfolio Alignment Stage
- Eliminate redundancies
- Prioritize
- Balance resources
- Mitigate risks
- Model alternative project portfolios
- Align all projects with resources and strategic goals
The Alignment Phase results means that each project in the portfolio is a candidate
for reclassification: from on-hold to active, from active to canceled, from idea to
feasibility, etc. It may be necessary to commit resources to generating ideas for
new potential projects to support strategic concerns that are not adequately
addressed in the current portfolio. The decisions made during the Alignment Phase
are designed to achieve the delicate balance between what is desired and what can
be achieved, between the theoretical ideal and the realistic optimum.
Deciding which projects to delay or cancel can be a particular challenge. In
conventional financial portfolio management, buying or selling investments
optimizes the portfolio. If an investment is under performing, and if it isn't being
held as part of a long-term diversification strategy, it's relatively easy to make the
decision to sell the investment and purchase something else. With a project
portfolio the decision is more complex since the perceived value may be different
for different stakeholders and the actual cost and projected benefits may be highly
subjective estimates.
During the Alignment Phase alternative project portfolios are evaluated by
modeling a number of “what-if” scenarios. For example, based on the reports run
during this phase, it's possible to create a list of projects that might be canceled or
delayed and then to model the effect on the project portfolio if these decisions were
implemented—or to model how you balance your objectives with your budgets.
The key challenge of the Alignment Phase is to avoid modifying the decision
criteria or the project data to make the current project portfolio appear more
optimal.

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iv) Portfolio Management Phase (Reallocation/Reprioritization/Reschedule)
- Delay, cancel and reschedule projects
- Redeploy resources
- Cancel projects
- Revise project budgets and schedule
- Initiate new projects
- Launch the portfolio process and portfolio changes.
Management should be able to view the project portfolio and have access to be
able to collaborate on issues such as project prioritization, categorizations, budgets,
go/kill milestones, scarce resource allocation, what projects to invest in and where
to invest and what to delay. This is the stage that true “Portfolio Management”
occurs, where projects are aligned with corporate or strategic goals, projects are
cut, budgets and resources redistributed, you can identify your architecture in terms
of your business. The challenge now becomes one of how to communicate the
portfolio information as actionable plans both horizontally and vertically within the
organization.
A major step in the Management Phase is mobilization and it requires that
department and project managers be given portfolio information in a format that
meets their specific needs and that directly feeds more detailed resource and
project management tools. This is the step where you implement the project
portfolio process and best practices
Selecting portfolio management tools
There is no single product solution that has all the functionality required hence the
need to look for an integrated solution. The integrated solution should include:
 Project Management Programs(s) with a database of all projects,
resources, milestones, budget, time recording, etc.
 Process Management System with a database of best practices,
standardized processes and templates
 Project Cost System with the ability to cost/estimate projects
 Human Resource System with a database of resources, skills and rates
 Project Portfolio Management System with the ability to create
credible models so Management can view the Project Portfolio from
the Top Down as well as Bottom Up.
1.4 Investment objectives and constraints
Investment objectives and constraints are the cornerstones of any investment
policy statement that need to be formally documented before commencing the
portfolio management. Any asset class that is included in the portfolio has to be
chosen only after a thorough understanding of the investment objective and
constraints.
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1.4.1 Investment objectives
These are related to what the client wants to achieve with the portfolio of
investments. They define the purpose of setting the portfolio and are concerned
with return and risk considerations. These two objectives are interdependent as
the risk objective defines how high the client can place the return objective.
The investment objectives are mainly of two types:
i) Risk objective
These are the factors that are associated with both the willingness and the ability of
the investor to take the risk. When the ability to accept all types of risks and
willingness is combined, it is termed as risk tolerance. When the investor is
unable and unwilling to take the risk, it indicates risk aversion.
The following steps are undertaken to determine risk objective:
- Specify Measure of Risk:
Measurement of risk is the most important issue in portfolio management. Risk
either measured in absolute or relative terms. Absolute risk measurement will
include a specific level of variance or standard deviation of total return. Relative
risk measurement will include a specific tracking risk.
- Investor’s Willingness:
Individual investors’ willingness to take risk is different from institutional
investors. For individual investors, willingness is determined by psychological or
behavioral factors. Spending needs, long-term obligations, wealth targets, financial
strength, and liabilities determine the investor’s willingness to take the risk.
- Investor’s Ability:
The ability of an investor to take risk is dependent on financial and practical
factors that bound the amount of risk taken by the investor. An investor’s short-
term horizon will negatively affect his ability. Similarly, if the investor’s obligation
and spending are less than his portfolio, he clearly has more ability.
- Risk and Safety of Principal (invested capital)
Investors must consider the amount of risk they are prepared to assume. In a
relatively efficient and informed capital market environment, risk tends to be
closely correlated with return. There is the risk of losing invested capital directly,
the danger of a loss in purchasing power the inherent risk in an asset that must be
considered and the extent to which that risk is being diversified away in a portfolio.
More aggressive investors may look toward longer-term debt instruments and
common stock, real assets, such as gold, silver, or valued art.
The age and economic circumstances of an investor are important variables in
determining an appropriate level of risk. Young, upwardly mobile people are
generally in a better position to absorb risk than are elderly couples on a fixed
income.

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Each of us, regardless of our plight in life, has different risk-taking desires. For
instance, because of an unwillingness to assume risk, a surgeon earning Sh.
3,000,000 a year may be more averse to accepting a Sh. 200,000 loss on a stock
than an aging taxicab driver.
ii) Investor’s return objective
The following steps are required to determine the return objective of the investor:
- Specify Measure of Return:
A measure of return needs to be specified. It can be specified in an absolute term or
a relative term; in nominal or real terms. Nominal returns are not adjusted for
inflation, real returns are. We distinguish pre-tax returns from post-tax returns.
- Desired Return:
The desired return indicates how much return is expected by the investor e.g.
higher or lower than average returns.
- Required Return:
A required return indicates the return which needs to be achieved at the minimum
for the investor.
- Specific Return Objectives:
These need to be determined so that they are consistent with his risk objectives. An
investor having a high return objective needs to have a portfolio with a high level
of expected risk.
- Current Income versus Capital Appreciation
In purchasing stocks, the investor with a need for current income may opt for high-
yielding, mature firms in such industries as public utilities, chemicals, or apparel.
Those searching for price gains may look toward smaller, emerging firms in high
technology, energy, or electronics. There is generally a trade-off between growth
and income. Finding both in one type of investment is unlikely.
- Liquidity Considerations
Liquidity is measured by the ability of the investor to convert an investment into
cash within a relatively short time at its fair market value or with a minimum
capital loss on the transaction. Most financial assets provide a high degree of
liquidity. Stocks and bonds can generally be sold within a matter of seconds at a
price reasonably close to the last traded value. This is not for real estate. Liquidity
can also be measured indirectly by the transaction costs or commissions involved
in the transfer of ownership. Financial assets generally trade on a relatively low
commission basis, whereas many real assets have high transaction costs.
- Short-Term versus Long-Term Orientation
In setting investment objectives, you must decide whether you will assume a short-
term or long-term orientation in managing the funds and evaluating performance.
You do not always have a choice.

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 - Ease of Management
The investor must determine the amount of time and effort that can be devoted to
an investment portfolio and act accordingly. In the stock market, this may
determine whether you want to be a daily trader or assume a longer-term
perspective. In real estate, it may mean the difference between personally owning
and managing a handful of rental houses or going in with 10 other investors to
form a limited partnership.
Assume an investor can add a 2 percent extra return to his portfolio but it takes 5
hours per week (260 hours per year) to do so. If his opportunity cost is Sh. 40 per
hour, he would have to add more than Sh.10,400 (Sh. 40*260 hours) to his
portfolio to make personal management attractive. If we assume a 2 percent excess
return can be gained over the professional manager, the investor would need a
portfolio of Sh. 520,000 (10,400*100%/2% before personal management would
make sense under these assumptions.
- Retirement and Estate Planning Considerations
The relatively young must begin to consider the effect of their investment
decisions on their retirement and the estates they will someday pass along to their
“potential families”. The concept of compound interest is that interest is added
back to the principal sum so that interest is earned on that added interest during the
next compounding period. Annual compound interest formula for annual
compound interest, including principal sum, is:
A = P (1 + r/n) (nt)
Where:
A = the future value of the investment/loan, including interest
P = the principal investment amount (the initial deposit or loan amount)
r = the annual interest rate (decimal)
n = the number of times that interest is compounded per year
t = the number of years the money is invested or borrowed for
Note that this formula gives you the future value of an investment or loan, which is
compound interest plus the principal.
Total compounded interest = P (1 + r/n) (nt) - P
A saving of Sh. 3,000 a year in a scheme for 5 consecutive years and the funds
earn 10 percent over that time will accumulate to Sh. 20,146.83 calculated as:
Annual Accumulated
Year Value Yearly contribution Interest rate interest amount
1 3,000 3000 0.10 300.00 3,300.00
2 6,300 3000 0.10 630.00 6,930.00
3 9,930 3000 0.10 993.00 10,923.00
4 13,923 3000 0.10 1,392.30 15,315.30
5 18,315 3000 0.10 1,831.53 20,146.83

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Private companies and governments have retirement plans e.g. teachers,
firefighters, and police, have a defined benefit plan. The defined benefit plan
specifies the amount of the retirement benefit based on income and years of
service.
In another example, an amount of Sh. 5,000 is deposited into a savings account at
an annual interest rate of 5%, compounded monthly, the value of the investment
after 10 years can be calculated as follows...
P = 5000. r = 5/100 = 0.05 (decimal). n = 12. t = 10.
If we plug those figures into the formula, we get:
A = 5000 (1 + 0.05 / 12)(12(10)) – 5,000 = 3235.05.
So, the investment balance after 10 years is Sh. 8,235.05.
A = 5000 (1 + 0.05 / 12)(12(10))
Using the order of operations we work out the totals in the brackets first. Thus
A = 5000 (1 + 0.0041666667)120
A = 5000 (1.0041666667)120
= 5000 x 1.6470095042509848
= 8235.0475.
1.5 Investment constraints
Investment constraints are the factors that restrict or limit the investment options
available to an investor. The constraints can be either internal or external. Internal
constraints are generated by the investor himself while external constraints are
generated by an outside entity, like a governmental agency.
Types of investment constraints
The following are the types of investment constraints:
i) Liquidity
Such constraints are associated with cash outflows expected and required at a
specific time in future and are generally in excess of income available. Moreover,
prudent investors will want to keep aside some money for unexpected cash
requirements.
ii) Time horizon
These constraints are related to the time periods over which returns are expected
from portfolio to meet specific needs in future. An investor may have to pay for
college education for children or needs the money after his retirement. Such
constraints are important to determine the proportion of investments in long-term
and short-term asset classes.
iii) Tax
An individual investor’s realized gains and income generated by his portfolio are
taxable. The tax environment needs to be kept in mind while drafting the policy
statement. Often, capital gains and investment income are subjected to differential
tax treatments.
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 iv) Legal and Regulatory
Legal and regulatory factors can act as an investment constraint. For example, a
trust could require that no more than 10% of the trust be distributed each year.
v) Unique Circumstances
Any special needs or constraints not recognized in any of the constraints listed
above would fall in this category e.g. the constraint an investor might place on
investing in a company that is not socially responsible, such as a tobacco company.
1.6 Investment strategies
1.6.1 Style Strategy
This approach to investing looks at the underlying characteristics common to
certain types of investments.
(i) Value style managers
They look for stocks that are incorrectly priced given the issuer's existing assets
and earnings. They employ traditional valuation measures that equate a stock's
price to the company's intrinsic value. Value companies tend to have relatively low
price/earnings ratios, pay higher dividends and have historically more stable stock
prices. The value manager's basic assumption is that the issuer's worth will, at
some point, be revalued and thereby generate gains. Standard & Poor's identified
three specific sub-styles: deep value, relative value and new value.
 Deep Value style
Uses the traditional Graham and Dodd approach whereby managers buy the
cheapest stocks and hold them for long periods in anticipation of a market
upswing.
 Relative Value money style
Managers seek out stocks that are under-appreciated relative to the market, their
peer group, and the company's earnings potential. A typical holding period is three
to five years. Unlike traditional value managers, relative value managers pursue
opportunities across all economic sectors and may not concentrate on the usual
"value sectors".
 New value
Managers choose their investments from all securities categories, seeking any
stock that holds prospect for significant appreciation.
(ii) Growth style managers
Typically focus on an issuer's future earnings potential. They try to identify stocks
offering the potential for growing earnings at above-average rates. They look to the
issuer's future earnings power. Growth is generally associated with greater upside
potential relative to style investing and, of course, it has concomitant greater
downside risk.
 Traditional growth style

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  Disciplined growth style
Managers concentrate on companies that they believe can grow their earnings at a
rate higher than the market average and that are selling for an appropriate price.
 Aggressive growth styles
Tend not to rely on traditional valuation methods or fundamental analysis. They
rely on technical analysis.
1.6.2 Sector Strategy
Looks at a particular industry such as transportation. Because the holdings of this
type of fund are in the same industry, there is an inherent lack of diversification
associated with these funds.
1.6.3 Index Strategy
Tends to track the index it follows by purchasing the same weights and types of
securities in that index, such as an S&P fund. Investing in an index fund is a form
of passive investing.
1.6.4 Global Strategy
A global strategist builds a diversified portfolio of securities from any country
throughout the globe. Global money managers may further concentrate on a
particular style or sector or they may choose to allocate investment capital in the
same weightings as world market capitalization weights.
1.6.5 Stable Value Strategy
Manager seeks short-term fixed income securities and guaranteed investment
contracts issued by insurance companies. These funds are attractive to investors
who want high current income and protection from price volatility caused by
movements in interest rates.
1.6.6 Dollar-Cost Averaging
This is implemented when an investor commits to investing a fixed dollar amount
on a regular basis, usually monthly purchase of shares in a mutual fund. When the
fund's price declines, the investor can buy a greater number of shares for the fixed
investment amount, and a lesser number when the share price is moves up.
1.6.7 Value Averaging
An investor adjusts the amount invested, up or down, to meet a prescribed target.
Suppose you are going to invest Sh. 2,000 per month in a mutual fund. At the end
of the first month, your initial Sh.2,000 investment has declined to Sh.1,900. In this
case, you would contribute Sh.2,100 the following month, bringing the value to
Sh.4,000 (2* Sh.2,000). Similarly, if the fund is worth Sh.4,300 at the end of the
second month, you only put in Sh.1,700 to bring it up to the Sh.6,000 target.
1.5.8 Foreclosure investment
A property is considered in foreclosure when the homeowner has not made a
mortgage payment for at least 90 days. The properties can be purchased before the
foreclosure auction or at the foreclosure auction which is a public sale.
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2. INVESTMENT IN REAL ESTATE
2.1 Real Estate
Real estate is property comprised of land and the buildings on it as well as the
natural resources of the land including uncultivated flora and fauna, farmed crops
and livestock, water and minerals.
Forms of Real Estate Investments
a. Free and Clear Equity
A free and clear equity investment confers full ownership for an indefinite period
of time. The investor gets all ownership rights. It is an outright purchase of the
asset with no encumbrances.
b. Leverage Equity
Leverage equity has same ownership rights as free and clear equity but is subject to
debt (promissory note) or a pledge (mortgage) to hand over those rights if
payments and terms of the debt are not met.
c. Mortgages
Mortgages are debt investments in which the mortgage holder receives a stream of
payments like a bondholder (principal and interest). Mortgage holders are a type of
real estate investor because they are entitled to take possession of the real estate
asset if the mortgagee defaults.
d. Aggregation Vehicles
Aggregation vehicles pool investors' funds together, giving them broader and
deeper access to the real estate market.
These include:
o Real estate limited partnerships
Allow groups of investors to participate in the real estate market with liability
limited to the amount of their original investment. Like other limited partnerships,
a real estate limited partnership is owned by one or more general partners who
handle the organization's operations, and by one or more limited partners who
participate financially but have no say in the management and operation of the
partnership.
o Commingled funds
Are pools of money made up of contributions from a number of different pension
plans or other funds. The money is managed by a professional money manager, be
it a bank, insurance company, or independent investment counselor. This is similar
to the Collective Investment Scheme (CIS), which are investment schemes wherein
several individuals come together to pool their money for investing in a particular
asset(s) and for sharing the returns arising from that investment as per the
agreement reached between them prior to pooling in the money.

16
 o REITs (Real Estate Investment Trusts)
Are a well-known type of closed end fund that buys, develops, manages and sells
real estate assets. REITs allow participants to invest in a professionally-managed
portfolio of real estate properties. They distribute or "pass-through" the majority of
their cash flows to investors. Most REIT revenues come principally from the rental
income their properties generate.
Real Estate Investment Trusts (REITS)
A REIT is a regulated investment vehicle that enables the issuer to pool investors’
funds for the purpose of investing in real estate. In exchange, the investors receive
units in the trust, and as beneficiaries of the trust, share in the profits or income
from the real estate assets owned by the trust.
Types of REITs
Income Real Estate Investment Trusts (I-REITs)
Is a real estate investment scheme which owns and manages income generating
real estate for the benefit of its investors therefore providing both liquidity and a
stable income stream. Distributions to investors are underpinned by commercial
leases. This means that income returns are generally predictable.
Development Real Estate Investment Trusts (D-REITs)
Is a development and construction real estate trust involved in the development or
construction projects for housing, commercial and other real estate assets.
Types of offers that can be issued in a REIT
REIT offers can be restricted or unrestricted. D-REIT offers are restricted, while I-
REIT offers/issue can either be restricted or unrestricted
Restricted Offer
Refer to issues or offers made to professional investors be they individuals or as
registered groups of persons, who subscribe for REIT securities worth at least
Kshs. 5.0 million; or any person licensed under the Capital Markets Act as a
professional investor, an authorized scheme or collective investment scheme or a
bank or subsidiary of a bank, insurance company, cooperative society, statutory
fund, pension or retirement fund.
Unrestricted Offer
Unrestricted I-REITs must be listed. They are structured as close ended funds. An
unrestricted offer is open to investors who need not be professional investors.
Real estate companies in Kenya: The number of Kenyans venturing in Real Estate
business is increasing exponentially mainly as a result of high profit margins
gained from a successful sale of land, properties or buildings.

17
Examples of real estate companies in Kenya
i) Villa Care
The firm offers a wide scope of real estate services, particularly specializing in real
estate consultancy, management and sale of residential properties and a variety of
commercial properties in Nairobi, Mombasa and East African region.
ii) Homes Universal
Is a consortium dealing with all the aspects of real-estate. The group includes
companies such as Villa Care, Homes Kenya Magazine, Sigimo Enterprises,
Mentor Group, Kenya Interiors, International Valuers, Security 24, Nairobi Best
Homes, etc.
iii) Knight Frank
Advising national and international commercial and residential developers,
investors, owners and occupiers Knight Frank Kenya fulfill a wide range of real
estate needs, including: property management, agency, valuation, project
management, feasibility and research-led consultancy.
iv) Hass Consult Ltd
The company offers a variety of services ranging from new property development
and consultancy to letting, selling and managing of residential and commercial
properties, and more recently valuations of all kinds of properties, including hotels,
businesses and industries
v) Lloyd Masika
A Registered Valuation and Estate Agency firm, providing professional valuation
and estate agent services in Kenya. It has been established since 1979 and is
structured in three main departments, which are complimentary in the provision of
services.
vi) Azizi Realtors
The company offering professional real estate consultancy and specializes in prime
properties, in Nairobi and the rest of the country.
vii) Suraya Property Group
A property development company in Africa which aims to innovate eco-friendly
and affordable developments.
viii) Dinara Developers
Offers development of quality and affordable housing selling of land.
ix) Homescope Properties Ltd
Deals with a diverse set of complex development projects across the country where
it has developed land mark properties.
x) Ryden International Ltd is dedicated to a standard of values that promote
honesty, trust and openness.

18
2.2 Joint Ventures in Real Estate
The main ways to invest in real estate include (i) development and exit through
selling or renting out, (ii) buying real estate products to realize capital gains and
rental yields, and (iii) buying real estate-backed structured products such as project
notes and Real Estate Investment Trusts (REITS). Landowners, in particular, are
increasingly interested in real estate development but are constrained by (i)
financial capability, (ii) development expertise, and (iii) time to do the
development themselves. Joint venture arrangements with reputable developers is
the most prudent way to tap into the real-estate-benefits.
Meaning of a Joint Venture
A joint venture (JV) refers to a business arrangement under which two or more
parties come together to undertake a project by pooling their resources together.
Real estate joint ventures combine the real estate development expertise and
financing capability of a developer with the landowner’s contribution in the form
of land.
Benefits of a Joint Venture
i. Increased capital base - Partners contribute capital into the project in the
form of land and/or cash. This is beneficial considering the capital-intensive
nature of real estate development.
ii. Development expertise - The developer provides development expertise in
terms of concept development, design and project management; and
oversees the project to completion. With the right partner, the landowner is
relieved of the day-to-day hustle of supervising a project and assured of a
professional workmanship,
iii. Access to market distribution channels - Partnering with a reputable real
estate firm that has been in the market ensures the real estate product reaches
its suited market.
iv. Can provide partial liquidity for landowner without having to sell the
entire land – The land owner can get some cash exit for their land to meet
their liquidity needs and also maintain interest in the development,
v. Preferred Returns – Landowners should insist on either preferred or
guaranteed minimum returns to ensure that in the event that the project does
not materialize, they do not lose the value of their land, and
vi. Shared risks and gains - Ultimately, a successful JV will generate the
expected high returns for both partners. A partnership also enables spreading
of economic and other market risks that might result from undertaking any
worthy real estate investment, and that would otherwise be borne alone.
The biggest risk and challenge in joint ventures is getting the right JV partner and
having the right governance structure to manage conflicts when they arise.

19
2.3 Sources of investment capital and leverage
Real estate assets are typically very expensive in comparison to other widely
available investment instruments (such as stocks or bonds). Only rarely will real
estate investors pay the entire amount of the purchase price of a property in cash. A
typical investment property generates cash flows to an investor in four general
ways:
 net operating income (NOI)
 tax shelter offsets
 equity build-up
 capital appreciation
i) Net operating income, or NOI
Net operating income is a profitability formula that is often used in real estate to
measure a commercial property’s profit potential and financial health by
calculating the income after operating expenses are deducted.
Real estate investors and creditors use this calculation to evaluate the cash flows of
a specific property and to formulate an initial value of the property. Other
industries refer to this calculation as EBIT or earnings before interest and taxes and
use it to base investment decisions on as well.
ii) Tax shelter offsets
Tax shelter offsets occur in one of three ways:
- depreciation,
- tax credits, and
- carryover losses which reduce tax liability charged against income from
other sources.
Some investments provide tax advantages by either eliminating or postponing
income tax on the investment income or growth.
iii) Equity build-up
Equity build-up is the increase in the investor's equity ratio as the portion of debt
service payments devoted to principal accrue over time.
Equity build-up counts as a positive cash flow from the asset where the debt
service payment is made out of income from the property or accelerated by making
additional contributions to the principal each month along with the normal
payment.
iv) Capital appreciation
Capital appreciation is the increase in market value of the asset over time,
realized as a cash flow when the property is sold. Capital appreciation can be very
unpredictable unless it is part of a development and improvement strategy.

20
2.4 Risk management
Management and evaluation of risk is a major part of any successful real estate
investment strategy. Risks occur in many different ways at every stage of the
investment process. Below is a tabulation of some common risks and typical risk
mitigation strategies used by real estate investors.
Risk Mitigation Strategy
Fraudulent sale Verify ownership, purchase title insurance
Adverse possession Obtain a boundary survey from a licensed surveyor
Environmental Obtain environmental survey, test for contaminants (lead paint,
contamination asbestos, soil contaminants, etc.)
Building component Complete full inspection prior to purchase, perform regular
or system failure maintenance
Obtain third-party appraisals and perform discounted cash flow
Overpayment at
analysis as part of the investment pro forma, do not rely on capital
purchase
appreciation as the primary source of gain for the investment
Maintain sufficient liquid or cash reserves to cover costs and debt
Cash shortfall
service for a period of time,
Purchase properties with distinctive features in desirable locations
Economic downturn to stand out from competition, control cost structure, have tenants
sign long term leases
Screen potential tenants carefully, hire experienced property
Tenant destruction of
managers
property
Carefully analyze financial performance using conservative
Underestimation of
assumptions, ensure that the property can generate enough cash
risk
flow to support itself
Purchase properties based on a conservative approach that the
Market Decline
market might decline and rental income may also decrease
Fire, flood, personal
Insurance policy on the property
injury
Tax Planning Plan purchases and sales around an exit strategy to save taxes.
2.5 Real estate appraisals
A real estate appraisal is an independent estimate of the value of a parcel of real
estate by an appraiser using approved, standardized methods. Appraisals are
opinions and will vary with the appraiser.

21
An appraisal determines value based on location, size, type of residential property,
income, and gross features of the property, such as the number of bathrooms and
bedrooms.
Appraisers do not look for latent defects or verify property boundaries, for
instance, which may have a large impact on the property value, neither does it
determine good title.
The appraisal process evaluates all of the data that may affect the value of the
property. The data can be classified broadly as general data such as the
neighborhood, city, and region of the real estate, and as specific data, which is the
information concerning the property itself. One general factor that is considered is
the absorption rate for a neighborhood, which is the number of months it would
take to sell the entire inventory of houses in the neighborhood. A value greater than
6 months is indicative of oversupply and will lower the appraised value.
2.5.1 Kinds of property value
There are 3 different kinds of property value that are related, but not necessarily
the same. These are market value, market price and market cost
1. Market value
The appraiser tries to determine the market value of the property, that is, the price
the property would probably sell for if the following characteristics are satisfied:
 buyer and seller act at arm's length and without pressure;
 buyer and seller are both well informed about the property, including its
potential and defects;
 the real estate is on the market long enough to attract some buyers.
The market value is deemed to be the most probable price at which the property
will sell. It is considered the cash price, so it does not take into consideration any
financial incentives or financing arrangements.
2. Market price
The market price is the price that the property actually sells for. It may be more or
less than the market value, particularly if either buyer or seller needs to complete
the transaction quickly, or if the transaction is not at arm's length, such as a sale
between relatives or friends.
3. Market cost
Market cost is what it would actually cost to buy the land and build the structures.
2.5.2 Determining Market Value
There are 3 general methods used to determine market value:
- Sales comparison
- Cost approach
- Income approach

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 1) Determining market value: Sales Comparison Approach
The subject property is compared to recently sold comparable properties.
Important characteristics to compare include:
 Location, especially if recently sold properties were in the same
neighborhood
o Considered features related to location include panoramic views from
the property, the amount of street traffic and noise, whether the
property is in a cul de sac, and whether it is adjacent to parks or
recreational areas.
 Size of structures and lots
 Sales prices within the last 6 months, with later prices carrying more weight
 Physical features, such as a garage, pool, patios, porches, or decks
 Condition of the property
 Construction quality
 Count of rooms, bedrooms, and bathrooms
 Floor plan
 Financing, since cash buyers can generally buy at lower prices and buyers
using seller financing tend to pay higher prices
2) Determining market value: Cost Approach
This approach considers what the land, devoid of any structures, would cost, then
adds the cost of actually building the structures, then depreciation is subtracted.
The cost approach is most often used for public buildings, such as schools and
churches, because it is difficult to find recently sold comparable properties in the
local market, and public buildings do not earn income, so the income approach
cannot be used, either.
- The cost approach method:
 Estimate what the vacant property would be worth.
 Estimate the current cost of building the structures, then add that value to the
value of the vacant land.
 Estimate the amount of accrued depreciation of the subject property, then
subtract it from the total to arrive at the property's worth.
There are 2 methods of estimating what it would cost to replace the structure:
1. The reproduction cost is the cost of duplicating the subject property's
structure completely.
2. The replacement cost is the cost of building a similar structure, but using
modern construction methods and materials.

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 - Estimating Reproduction or Replacement Cost
There are 3 major methods of estimating the reproduction or replacement cost:
1. The square-foot method takes the cost per square foot of a recently
developed comparable property and multiplies it by the square footage,
using the external dimensions of the structures of the subject property.
2. The unit-in-place method estimates the cost of the subject property by
summing the costs of the individual components of the structures, such as
materials, labor, overhead, and profit.
3. The quantity-survey method estimates the separate costs of construction
materials (wood, plaster, etc.), labor, and other factors and adds them
together. This method is the most accurate and the most expensive method,
and is mainly used for historical buildings.
 Vacant Land Appraisal
Vacant land is generally valued as if it were used for its best use, regardless of its
present use, which is generally done by comparing it with other similar properties
put to its best use. Vacant land can only be appraised using the sales comparison
approach, since vacant land is not constructed nor does it earn an income. The
determination of land value is necessary in both the cost approach and the sales
approach to estimate depreciation, since land is not depreciable.
 Depreciation
In estimating property value using the cost approach, depreciation is subtracted
from the total value. Depreciation as used in real estate appraisals has a slightly
different meaning than it has in taxation. Depreciation is the loss of value due to
all causes. Land does not depreciate, unless it is degraded by erosion, improper
use, or perhaps zoning changes. Depreciation can be classified according to its
cause:
 Physical deterioration is the deterioration of structures due to wear and
tear.
 Functional obsolescence is a loss of value associated with features that have
been discounted by the market, such as unfashionable design features,
outdated plumbing, electrical, or heating systems, or inadequate insulation.
 External obsolescence is a loss of value caused by changes in external
factors, such as changes in the surrounding property, environment, zoning,
or other factors that may decrease the property value, such as increasing
crime or a change in zoning.

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 3) Determining market value: Income Approach
The income approach values property by the amount of income that it can
potentially generate. Hence, this method is used for apartments, office buildings,
malls, and other property that generates a regular income. The appraiser calculates
the income according to the following steps:
1. Estimate the potential annual gross income by doing market studies to
determine what the property could earn, which may not be the same as what
it is currently earning.
2. The effective gross income is calculated by subtracting the vacancy rate and
rent loss as estimated by the appraiser using market studies.
Effective Gross Income = Gross Income - Vacancy Rate - Rent Loss
3. The net operating income is calculated by subtracting the annual operating
expenses from the effective gross income. Annual operating expenses
include real estate taxes, insurance, utilities, maintenance, repairs,
advertising and management expenses. The cost of capital items is not
included, since it is not an operating expense. Hence, it does not include
mortgage and interest, since this is a debt payment on a capital item.
- Formula for NOI
Net Operating Income = Effective Gross Income – Operating Expenses
Example
An investor purchases a building for Sh. 50 million in cash. It has 15 apartments
and generates rent of Sh.50,000 per month from each apartment. It has 50 parking
spaces that generate Sh. 10,000 per month each. The property pays maintenance
fees of Sh. 100,000 per month, janitorial fees of Sh. 120,000 per month, utility
costs of Sh. 150,000 per month and property taxes of Sh. 500,000 per year.
The property generates a net income of Sh.10,060,000 million calculated as:
Sh. Sh.
Rental income Sh. 50,000 x 15 apartments x12 months 9.000.000
Parking spaces Sh.10,000 x 50 spaces x 12 months 6,000,000 15,000,000
Expenses:
Maintenance Sh. 100,000x 12 months 1,200.000
Janitorial Sh. 120,000x 12 months 1,440,000
Utility Sh. 150,000x 12 months 1,800,000
Rates 500,000 4,940,000
Net income 10,060,000
a) Income approach: Capitalization rate
Estimate the capitalization rate, which is the rate of return, or yield, that other
investors of property are getting in the local market.
Capitalization Rate = Net Operating Income / Purchase Price or Property Value

25
A property's capitalization is calculated by dividing its annual NOI by the potential
total sale price of the property. That is
Capitalization rate = Annual NOI/potential sales price
Assume the apartment building has a sale price of Sh. 80 million after two years
due to the increased demand of real estate in the investor's city. However, the
property's rent prices and operating expenses remain the same. Therefore, the
capitalization rate of the property is 12.58% (Sh. 10,060,000/Sh. 80,000,000).
Determine property value
Property Value = Net Operating Income / Capitalization Rate
The capitalization rate is equal to the interest rate for bonds or the E/P ratio for
stocks: more desirable properties will have lower capitalization rates than less
desirable properties because Treasuries have lower interest rates than junk bonds or
high-growth companies have lower earnings-to-price ratios than companies that are
not growing.
Example of determining best value for investment:
You buy an 4-room apartment for rental income for Sh.2,000,000 total and rent the
rooms for Sh.5,000 per month each, and total operating costs for each room is
Sh.2,000 per month. The net annual operating income is calculated as:
 Net Annual Operating Income = [(Sh.5,000 × 4) - (Sh.2,000 × 4)] × 12 =
Sh.144,000
 Capitalization Rate = Sh.144,000 / Sh.2,000,000 = 0.07 = 7%
The capitalization rate is the rate of return on investment and can be used to
compare rental properties to other investments.
b) Income approach: Gross Rent Multiplier
The gross rent multiplier (GRM) is used to value residential properties with 1 to
4 units. The formula is:
GRM = Sales Price / Monthly Rent
The appraiser does not use the current rent since it may not be the market rent, but
uses recent rental information from at least 4 comparable properties.
GRM Examples for Residential Properties
Property Sales Price (Sh) ÷ Monthly Rent (Sh) = GRM
Bedsitter at Githurai 20,000,000 ÷ 200,000 = 100
3-bedroom at Hilltop 135,000,000 ÷ 120,000 = 112.50

Market Value of Residential Property = GRM × Monthly Income

Example Determining Increase in Market Value by Gross Rent Multiplier
A 4-apartments building rented for Sh.50,000 per month each was purchased for
Sh.12,000,000, then:

26
  Total Monthly Income = Sh.50,000 × 4 = Sh.200,000
 Gross Rent Multiplier = Sh.12,000,000 / Sh.200,000 = 60
If rent is raised to Sh.60,000 and still keep the tenants, then the property is worth:
Property Value = GRM × Monthly Income = 60 × Sh.240,000 = Sh.14,400,000.
c) Income approach: Gross income multiplier
The annual gross income is used to evaluate commercial property, so it is natural
to use the gross income multiplier (GIM), calculated like the GRM, but using
annual gross income instead of monthly rents.
GIM = Sales Price / Annual Gross Income
GIM Examples for Commercial Properties
Commercial Property Sales Price ÷ Annual Gross Income = GIM
ABC Properties Sh.3,000,000 ÷ Sh.400,000 = 7.5
Woodridge Complex Sh.4,000,000 ÷ Sh.550,000 = 7.3
Once the multiplier is found, the value of the subject property can be estimated:
Market Value of Commercial Property = GIM × Gross Income
2.6 The primary cause of investment failure
The investor goes into negative cash flow for a period of time that is not
sustainable, often forcing them to resell the property at a loss or go into insolvency.
A similar practice known as flipping is another reason for failure as the nature of
the investment is often associated with short term profit with less effort. Individual
properties are unique to themselves and not directly interchangeable, which
presents a major challenge to an investor seeking to evaluate prices and investment
opportunities. Information asymmetries are commonplace in real estate markets.
This increases transactional risk, but also provides many opportunities for investors
to obtain properties at bargain prices.

27
 3. ANALYSIS OF EQUITY SECURITIES
Analysis of securities means evaluating a security to assess its value. Two methods
are used. Fundamental analysis is a method of evaluating a security to assess its
intrinsic value, by examining related economic, financial, and other qualitative and
quantitative factors. Fundamental analysts study macroeconomic factors (e.g.
economy and industry conditions) and microeconomic factors (e.g. financial
conditions and company management). The end goal of fundamental analysis is to
produce a quantitative value that an investor can compare with a security's current
price, thus indicating whether the security is undervalued or overvalued. Technical
analysis uses market statistics. To perform technical analysis, investors start with
charts that show the price and trading volume history of a particular security or
index (for example, the Dow Jones Industrial Average) and other statistical
measures like moving averages, maximums and minimums, percentage changes.
3.1 Securities Valuation
Securities Valuation means determining the market value of equity instruments
(common stock and preferred stock), debt instruments (options and futures) issued
by government agencies, financial institutions and corporate organizations.
Valuation is the estimation of an asset’s value based either on variables perceived
to be related to future investment returns or on comparisons with similar assets.
It is critical to determine the fair value (intrinsic value or fundamental value) of the
security. Some of the investments decisions or recommendations are:
d) Buy. When the decision is to buy the asset, the next is to decide when to buy
the asset.
e) Hold. The decision may be to hold the asset. The next decision still remains
the time when to hold the asset and when it will be reviewed again.
f) Sell. The decision to sell will require to decide the appropriate time to sell it.
3.2 Investment Valuation Models
3.2.1 General Approach
1. These models assume that the stock is bought, held for some time, dividends
and other cash distributions are collected, and then sold.
2. The stock is valued as the present value of the expected cash distributions
and the expected proceeds from the sale also called the “intrinsic value.”
3. Periodic cash distributions are referred to generically as “dividends.”
Dividends include any cash distributed to shareholders, in particular through share
buybacks. Assume that dividends are paid annually and that the time 0 dividend
has just been paid. If the stock is held one year, the return, r, on the stock is
r = Dt+Pt – 1
P0
where Dt is firms dividend per share at time t and P t is the stock price of the firm at
time t. which is known as a dividend discount model (DDM).
28
 3.2.2 The Price/Earnings Ratio (P/E ratio)
The price/earnings ratio (P/E) is the best known of the investment valuation
indicators. It has its imperfections, but it is the most widely reported and used
valuation by investment professionals and the investing public. The formula for
calculating the price/earnings ratio is:
Price Earnings Ratio = Stock Price per Share
Earnings per Share
Indication: A stock with a high P/E ratio suggests that investors are expecting
higher earnings growth in the future compared to the overall market, as investors
are paying more for today's earnings in anticipation of future earnings growth.
3.3 Approaches to Expected Return Determination
3.3.1 The capital asset pricing model (CAPM)
CAPM uses the security market line (SML). This approach allows the investor to
explicitly make adjustments to the beta estimate to reflect the assessment of the
future beta of the stock. If valuing existing equity, it can also use a historical
average return as an estimate of expected return. The model can also adjust the
estimate to take into account the predictability of returns and to allow for the
sensitivity of the stock to other sources of risk.
- Calculating expected return using The 'Capital Asset Pricing Model
CAPM is a model that describes the relationship between systematic risk and
expected return for assets, particularly stocks. It is used throughout finance for the
pricing of risky securities, generating expected returns for assets given the risk of
those assets and calculating costs of capital. The formula for calculating the
expected return of an asset given its risk is as follows:

The general idea behind CAPM is that investors need to be compensated in two
ways: time value of money and risk. The time value of money is represented by
the risk-free (rf) rate in the formula and compensates the investors for placing
money in any investment over a period of time. The risk-free rate is customarily
the yield on government bonds. The other half of the CAPM formula represents
risk and calculates the amount of compensation the investor needs for taking on
additional risk. This is calculated by taking a risk measure (beta) that compares the
returns of the asset to the market over a period of time and to the market premium
(Rm-rf): the return of the market in excess of the risk-free rate.

29
Beta reflects how risky an asset is compared to overall market risk and is a
function of the volatility of the asset and the market as well as the correlation
between the two. For stocks, the market is usually represented as the S&P 500 but
can be represented by more robust indexes as well.
Decision rule: If this expected return does not meet or beat the required return,
then the investment should not be undertaken.
Example of CAPM
The risk-free rate is 2% and the beta (risk measure) of a stock is 2. The expected
market return over the period is 10%, so the market risk premium is 8% (10% -
2%). Plugging in the preceding values into the CAPM formula above, we get an
expected return of 18% for the stock:
18% = 2% + 2 x (10%-2%)
Assumptions of CAPM
The following is a set of assumptions which are sufficient to allow a simple
derivation of the model.
(a) The market is composed of risk-averse investors who measure risk in terms
of standard deviation of portfolio return. This assumption provides a basis
for the use of beta-type risk measures.
(b) All investors have a common time horizon for investment decision making
(e.g., 1 month, 1 year, etc.). This assumption allows us to measure investor
expectations over some common interval, thus making comparisons
meaningful.
(c) All investors are assumed to have the same expectations about future
security returns and risks. Without this assumption, investors would
disagree on expected return and risks, resulting in a more complex situation.
(d) Capital markets are perfect in the sense that all assets are completely
divisible, there are no transactions costs or differential taxes, and borrowing
and lending rates are equal to each other and the same for all investors.
Without these conditions, frictional barriers would exist to the equilibrium
conditions on which the model is based.
3.3.2 Dividend Discount Model (DDM)
Also known as the Gordon Growth Model. It is a method of valuing a company's
stock price based on the theory that its stock is worth the sum of all of its future
dividend payments, discounted back to their present value. In other words, it is
used to value stocks based on the net present value of the future dividends.
The formula used is:
P = D1
r-g

30
Where P is the current stock price, g is the constant growth rate in perpetuity
expected for the dividends, r is the constant cost of equity capital for that company,
D1 is the value of the next year's dividends.
i) Stable DDM Model
The stable model assumes that dividends grow at a constant rate. Assume XYZ
Company intends to pay a Sh.10 dividend per share next year and expects this to
increase by 5% per year thereafter and the required rate of return on XYZ
Company stock is 10%. Currently, XYZ Company stock is trading at Sh.100 per
share. Using the formula above, we can calculate that the intrinsic value of one
share of XYZ Company stock is:
Intrinsic value = Sh.10/(.10-.05) = Sh.200
Thus, XYZ Company stock is worth Sh.200 per share but is trading at Sh.100; the
Gordon Growth Model suggests the stock is undervalued.
ii) Multistage Growth DDM Model
Assume that during the next few years XYZ Company's dividends will increase
rapidly and then grow at a stable rate. Next year's dividend is still expected to be
Sh.10 per share, but dividends will increase annually by 7%, then 10%, then 12%,
and then steadily increase by 5% after that. By using elements of the stable model,
but analyzing each year of unusual dividend growth separately, we can calculate
the current fair value of XYZ Company stock.
Here are the inputs:
D1 = Sh.10.00
k = 10%
g1 (dividend growth rate, year 1) = 7%
g2 (dividend growth rate, year 2) = 10%
g3 (dividend growth rate, year 3) = 12%
gn (dividend growth rate thereafter) = 5%
Since we have estimated the dividend growth rate, we can calculate the actual
dividends for those years:
D1 = Sh.10.0
D2 = Sh.10.0 * 1.07 = $10.7
D3 = Sh.10.7 * 1.10 = $11.8
D4 = Sh.11.8 * 1.12 = $13.2
We then calculate the present value of each dividend during the unusual growth
period:
Sh.10.00 / (1.10) = Sh.9.1
Sh.10.7 / (1.10)2 = Sh.8.8
Sh.11.8 / (1.10)3 = Sh.8.9
Sh.13.2 / (1.10)4 = Sh.9.0

31
Then, we value the dividends occurring in the stable growth period, starting by
calculating the fifth year's dividend:
D5 = Sh.13.2*(1.05) = Sh.13.9
We then apply the stable-growth Gordon Growth Model formula to these dividends
to determine their value in the fifth year:
Sh.13.9 / (0.10-0.05) = Sh.278
The present value of these stable growth period dividends are then calculated:
Sh.278 / (1.10)5 = Sh.172.6
Finally, we can add the present values of Company XYZ's future dividends to
arrive at the current intrinsic value of Company XYZ stock:
Sh.9.1+ Sh.8.8+ Sh.8.9+ Sh.9.0+ Sh.172.6 = Sh.208.4
The multistage growth model also indicates that Company XYZ stock is
undervalued (a Sh.208.4 intrinsic value, compared with a Sh.100 trading price).
Mathematically, two circumstances are required to make the Gordon Growth
Model effective. First, a company must distribute dividends. Second, the dividend
growth rate (g) cannot exceed the investor's required rate of return (k). If g is
greater than k, the result would be negative, and stocks cannot have negative
values.
The Gordon Growth Model, especially the multistage growth model, often requires
users to make somewhat unrealistic difficult estimates of dividend growth rates (g).
3.3.3 Accounting rate of return - (ARR)
The ARR method (also called the return on capital employed (ROCE) or the return
on investment (ROI) method) of appraising a capital project is to estimate the
accounting rate of return that the project should yield.

Where:
C is the net annual profit
D is the depreciation
I is the initial cost outlay
Decision Rule-ARR: Accept the project if its ARR is equal to or greater than the
required accounting rate of return or the one with highest ARR for mutually
exclusive projects.
Example 1: Calculating ARR
A project has an initial outlay of $1 million and generates net receipts of $250,000
for 10 years.
Assuming straight-line depreciation of $100,000 per year:

= 15%
32
= 30%
Example 2: Calculating ARR
An investment of Sh.130,000 is expected to generate annual cash inflow of
Sh.32,000 for 6 years. Depreciation is allowed on the straight line basis. The
project will generate scrap value of Sh.10,500 at end of the 6th year. Calculate its
accounting rate of return assuming there are no other expenses on the project.
Solution
Annual Depreciation = (Initial Investment − Scrap Value) ÷ Useful Life in Years
Annual Depreciation = (Sh.130,000 − Sh.10,500) ÷ 6 ≈ Sh.19,917
Average Accounting Income = Sh.32,000 − Sh.19,917 = Sh.12,083
Accounting Rate of Return = Sh.12,083 ÷ Sh.130,000 ≈ 9.3%
Example 3: Calculating ARR
Compare the following two mutually exclusive projects on the basis of ARR. Use
the straight line depreciation method.
Project A
Year 0 1 2 3
Cash outflow 220,000
Cash inflow 91,000 130,000 105,000
Salvage value 10,000
Project B
Year 0 1 2 3
Cash outflow 198,000
Cash inflow 87,000 110,000 84,000
Salvage value 18,000
Solution
Project A
Step 1: Annual depreciation = (220,000 – 10,000)/3 = 70,000
Step 2:
Year 1 2 3
Cash inflow 91,000 130,000 105,000
Salvage value 10,000
Depreciation (70,000) (70,000) (70,000)
Accounting income 21,000 60,000 45,000

33
Step 3: Average Accounting Income = (21,000+60,000+45,000)/3 = 42,000
Step 4: Accounting Rate of Return = (42,000/220,000)*100 = 19.09%
Project B
Step 1: Annual depreciation = (198,000 – 18,000)/3 = 60,000
Step 2:
Year 1 2 3
Cash inflow 87,000 110,000 84,000
Salvage value 18,000
Depreciation 60,000 60,000 60,000
Accounting income 27,000 50,000 42,000
Step 3: Average Accounting Income = (27,000+50,000+42,000)/3 = 39,666
Step 4: Accounting Rate of Return = (39,666/198,000)*100 = 20.03
Since ARR of the Project B is higher, it is more favorable than Project A
Advantages of ARR
- This method of investment appraisal is easy to calculate.
- It recognizes the profitability factor of investment.
Disadvantages of ARR
- It ignores time value of money. If we use ARR to compare two projects
having equal initial investments the project which has higher annual income
in the latter years of its useful life may rank higher than the one having
higher annual income in the beginning years, even if the present value of the
income generated by the latter project is higher.
- It can be calculated in different ways. Thus there is problem of consistency.
- It uses accounting income rather than cash flow information. Thus it is not
suitable for projects which have high maintenance costs because their
viability also depends upon timely cash inflows.
- Its implicitly assumes stable cash receipts over time.
- It is based on accounting profits and not cash flows. Accounting profits are
subject to a number of different accounting treatments.
- It is a relative measure rather than an absolute measure and hence takes no
account of the size of the investment.
- It takes no account of the length of the project.
3.3.4 Net Present Value (NPV) Method
The net present value is the difference between the initial outlay and the present
value of the cash flows generated during the life of the project and the salvage
value
Decision rule:
If NPV is positive (+): accept the project. If NPV is negative(-): reject the project

34
 i) Present value
We can derive the Present Value (PV) by using the formula:
PVn = Vo (I + r)n
By denoting Vo by PV we obtain:
PVn = PV (I + r)n
by dividing both sides of the formula by (I + r)n we derive:

Exercise 1: Calculating Present value

i) Calculate the present value of Sh11,000 at the end of one year at an
interest rate of 10%.
PV = FV1/(1+0.1)1
= Sh11,000/1.1 = Sh. 10,000
ii) calculate the PV of Sh.16,100 at the end of 5 years?
PV = FV5/(1+0.1)5 = Sh. 16,100/1.610 = Sh. 10,000
ii) Example 2: Calculating Net present value (NPV)
The NPV method is used for evaluating the desirability of investments or projects.

where:
Ct = the net cash receipt at the end of year t
Io = the initial investment outlay
r = the discount rate/the required minimum rate of return on investment
n = the project/investment's duration in years.
The discount factor r can be calculated using:

Example 3: Calculating NPV

Exercise: Net present value (NPV)

A firm intends to invest Sh.10,000 in a project that generates net receipts of
Sh.8,000, Sh.9,000 and Sh.6,000 in the first, second and third years respectively.
Should the firm go ahead with the project?

35
NPV = Sh.10,000 [(Sh.8000*.9091)+(Sh.9,000*.8264)+(Sh.6,000*.7513)]
= Sh. 10,000-(Sh.7,272.80 + Sh.7,437.60+ Sh. 4,507.80) = Sh.9,218.20
3.3.5 Future Value
Future value (FV) is the value in shillings at some point in the future of one or
more investments.
FV consists of:
i) the original sum of money invested, and
ii) the return in the form of interest.
The general formula for computing Future Value is as follows:
FVn = Vo (l + r)n
where
Vo is the initial sum invested, r is the interest rate, n is the number of periods for
which the investment is to receive interest.
Thus we can compute the future value of what Vo will accumulate to in n years
when it is compounded annually at the same rate of r by using the above formula.
Example: Future values/compound interest
i) Calculate the future value of $10 invested at 10% at the end of 1 year.
FVn = Vo (l + r)n
FV1 = Sh. 10,000 (l + 0.10)1 = 9,090
ii) Calculate the future value of $10 invested at 10% at the end of 5 years.
FV5 = Sh. 10,000 (l + r)5
= Sh 10,000(1.61051) = 16,105.10
The term (l + r)n gives the future value interest factor (FVIF) is calculates as:
((1.1)(1.1)(1.1)(1.1)(1.1)=1.61051)
3.3.6 Annuities
Annuities are a set of cash flows that are equal in each and every period.
Example: Calculation of PV of an annuity
A firm invests Sh. 800 in a project that is expected to generate Sh. 400 yearly for
three years. The present value of the annuity can be calculated as:
PV = Sh.400 (0.9091) + Sh.400(0.8264) + Sh.400(0.7513)
= Sh.363.64 + Sh.330.56 + Sh.300.52 = Sh.994.72
NPV = Sh.994.72 - Sh.800.00 = Sh.194.72
Alternatively,
PV of an annuity = $400 (PVFAt.i) (3,0,10)
= $400 (0.9091 + 0.8264 + 0.7513)
= $400 x 2.4868 = $994.72
NPV = $994.72 - $800.00 = $194.72
3.3.7 Perpetuities
This is an annuity with an infinite life. It is an equal sum of money to be paid in
each period forever. The formula for calculating PV of a perpetuity is:
36
where:
C is the sum to be received per period
r is the discount rate or interest rate
Example: Calculation of PV of a perpetuity
You are promised a perpetuity of $700 per year at a rate of interest of 15% per
annum. What price (PV) should you be willing to pay for this income?

= $4,666.67
Example: Calculation of PV of a perpetuity with growth:
Suppose that the $700 annual income most recently received is expected to grow
by a rate G of 5% per year (compounded) forever. How much would this income
be worth when discounted at 15%?
Solution:
Subtract the growth rate from the discount rate and treat the first period's cash flow
as a perpetuity.

= $735/0.10
= $7,350
3.3.8 The internal rate of return (IRR)
The IRR is the discount rate at which the NPV for a project equals zero. This rate
means that the present value of the cash inflows for the project would equal the
present value of its outflows. The IRR is the break-even discount rate. The IRR is
found by trial and error.

where r = IRR
IRR of an annuity:

where:
Q (n,r) is the discount factor
Io is the initial outlay
C is the uniform annual receipt (C1 = C2 =....= Cn).

37
Example: Calculation of Internal Rate of Return (IRR)
What is the IRR of an annual income of $20 per year for 7 years and costs $120?

=6
From the Present value interest factor of an (ordinary) annuity PVIFA(i,n) tables =
4%
Decision rule for IRR: If IRR exceeds cost of capital, project is worthwhile, i.e. it
is profitable to undertake.
3.3.9 The payback period (PP)
The payback as 'the time it takes the cash inflows from a capital investment project
to equal the cash outflows, usually expressed in years'.
Decision Rule: To accept the project with the shortest payback.
Example 1: Payback period
Years 0 1 2 3 4 5
Project A 1,000,000 250,000 250,000 250,000 250,000 250,000
For a project with equal annual receipts:

= 4 years
Example 2: Payback period
Years 0 1 2 3 4
Project B - 10,000 5,000 2,500 4,000 1,000
Payback period lies between year 2 and year 3. Sum of money recovered by the
end of the second year
= $7,500, i.e. ($5,000 + $2,500)
Sum of money to be recovered by end of 3rd year
= $10,000 - $7,500 = $2,500

= 2.625 years
Disadvantages of the payback method:
- It ignores the timing of cash flows within the payback period, the cash flows
after the end of payback period and therefore the total project return.
- It ignores the time value of money. It does not take into account the fact that
Sh1 today is worth more than Sh1 in one year's time.

38
 An investor who has Sh1 today can either consume it immediately or invest
it at the prevailing interest rate, say 30%, to get a return of Sh1.30 in a year's
time.
- It is unable to distinguish between projects with the same payback period.
- It may lead to excessive investment in short-term projects.
Advantages of the payback method:
Payback can be important: long payback means capital tied up and high investment
risk. The method also has the advantage that it involves a quick, simple calculation
and an easily understood concept.
Exercise: Payback and ARR
Delta Corporation is considering two capital expenditure proposals. Both
proposals are for similar products and both are expected to operate for four years.
Only one proposal can be accepted.
Proposal A Proposal B
Initial investment 16,000 16,000
Year 1 7,500 4,500
Year 2 4,500 2,500
Year 3 13,500 4,500
Year 4 -1,500 14,500
Estimated scrap value- end of Year 4 4,000 4,000
Depreciation is charged on the straight line basis. = (16,000-4,000)/4 = 3,000
i) The payback period
Proposal A
Years 0 1 2 3 4
Cash flows (16,000) 7,500 4,500 13,500 (1,500)
Depreciation 3,000 3,000 3,000 3,000
Net profit 4,500 1,500 10,500 1,500
Salvage value 4,000
Net profit recovered in years 1 and 2 = (4,500+1,500) = 6,000
Net profit recovered in year 3 = (16,000 – 6,000) = 10,000
Payback period = 2+ (10,000/10,500) = 2.95 days
Initial outlay in Proposal A will be recovered within 2.95 days.

39
Proposal B
Years 0 1 2 3 4
Cash flows (16,000) 4,500 2,500 4,500 14,500
Depreciation 3,000 3,000 3,000 3,000
Net profit 1,500 (500) 1,500 11,500
Salvage value 4,000
Net profit recovered in years 1 through 4 = (1,500-500+1,500 +11,500) = 14,000
Investment in Proposal B will not be recovered within the four years.
ii) The average rate of return (ARR) on initial investment.
Proposal A
Average annual profit (4,500+1,500+10,500+1,500)/4 = 4,500
ARR = Average net profit/average investment outlay = 4,500/(16,000/2) = 56.25%
Proposal B
Average annual profit (1,500-500+1,500+11,500)/4 = 3,500
ARR = Average net profit/average investment outlay
= 3,500/(16,000/2) = 43.75%

40
 4. THE CONCEPT OF RISK AND RETURN
4.1 Risk and return
i) Risk
Risk is the uncertainty that an investment will earn its expected rate of return.
Greater uncertainty results in greater likelihood that the investment will generate
larger gains, as well as greater likelihood that the investment will generate larger
losses (in the short term) and in higher or lower accumulated value (in the long
term.) But because there is uncertainty that the portfolio will earn its expected
long-term return, the long-term realized return may fall short of the expected return
or exceed the expected return. Risk is measured using the standard deviation.
a) Standard deviation
Definition of Standard Deviation
- A measure of the dispersion of a set of data from its mean. The more spread
apart the data, the higher the deviation. Standard deviation is calculated as
the square root of variance.
- In finance, standard deviation is applied to the annual rate of return of an
investment to measure the investment's volatility. Standard deviation is also
known as historical volatility and is used by investors as a gauge for the
amount of expected volatility.
Standard deviation is a statistical measurement that sheds light on historical
volatility. For example, a volatile stock will have a high standard deviation while a
stable blue chip stock will have a lower standard deviation. A large dispersion tells
us how much the fund's return is deviating from the expected normal returns.
Example of Calculating Standard Deviation
We want to calculate the standard deviation for the amounts of gold coins on a ship
which has a population of 5. If we know the amount of gold coins each of the 5
people have, then we use the standard deviation equation for an entire population:

The amounts of gold coins the 5 people have are 4, 2, 5, 8, 6.

41
We follow the steps below to calculate the standard deviation:
1. Calculate the mean:

2. Calculate for each value in the sample:

3. Calculate :

4. Calculate the standard deviation:

The standard deviation for the amounts of gold coins the pirates have is 2.24
gold coins.
The calculations of steps 1 to 3 are summarized on this table
Data Mean Distance from mean Distance from mean squared
4 5 -1 1
2 5 -3 9
5 5 0 0
8 5 3 9
6 5 1 1
Mean = 25/5=5 0 20
Step 3: Sum the values from Step 2. The sum is 20

42
Step 4: Divide the results from step 3 by the number of data points.
Divide the results of step 3 by the variable n, which is the number of data points.
20/(5-1) = 5
Step 5: Take the square root of the result from step 4.
Just take the square root of the answer from Step 4.
= √20/(5 − 1)
= √5
=2.24
b) BETA
Beta is a measure of the volatility, or systematic risk, of a security or a portfolio, in
comparison to the market as a whole. Beta is the tendency of a security's returns to
respond to swings in the market. A beta of 1 indicates that the security's price will
move with the market. A beta of less than 1 means that the security will be less
volatile than the market. A beta of greater than 1 indicates that the security's price
will be more volatile than the market. For example, if a stock's beta is 1.2, it's
theoretically 20% more volatile than the market.
A Negative beta - A beta less than 0 - would indicate an inverse relation to the
market - is possible but highly unlikely. Some investors used to believe that gold
and gold stocks should have negative betas, because they tended to do better when
the stock market declined, but this hasn't proved to be true over the long term.
A Beta of 0 - Basically, cash has a beta of 0. In other words, regardless of which
way the market moves, the value of cash remains unchanged (given no inflation).
Beta between 0 and 1 - Companies with volatilities lower than the market have a
beta of less than 1 (but more than 0). Many utilities fall in this range.
Beta of 1 - A beta of 1 represents the volatility of the given index used to represent
the overall market, against which other stocks and their betas are measured e.g.
S&P 500. If a stock has a beta of one, it will move the same amount and direction
as the index. An index fund that mirrors the S&P 500 will have a beta close to 1.
Beta greater than 1 - This denotes a volatility that is greater than the broad-based
index. Many technology companies on the Nasdaq have a beta higher than 1.
By using beta to measure volatility, investors can better choose those securities that
meet the criteria for risk. Investors who are very risk averse should put their money
into investments with low betas, such as utility stocks and treasury bills. Those
investors who are willing to take on more risk may want to invest in stocks with
higher betas.
ii) Return
A rate of return is measure of profit as a percentage of investment.

43
Suppose A invests Sh.500,000 in a business, and the business makes a profit of
about Sh.60,000 a year The rate of return in one year is simply the profits as a
percentage of the investment, or Sh.60,000/Sh.500,000 = 12%.
iii) The relationship between expected return and risk
The risk/return tradeoff is the balance between the desire for the lowest possible
risk and the highest possible return. It is about determining what risk level is most
appropriate for an investor. Low levels of uncertainty (low risk) are associated with
low potential returns. High levels of uncertainty (high risk) are associated with
high potential returns. This is demonstrated graphically in the chart below. A
higher standard deviation means a higher risk and higher possible return.

Risk tolerance differs from investor to investor. An investor’s preference depends

on their goals, income and personal situation. On the lower end of the risk-return
trade-off scale, the risk-free rate of return is represented by the return on
Government Securities because their chance of default is next to nothing. If the
risk-free rate is currently 6%, this means, with virtually no risk, we can earn 6%
per year on our money.
No investor wants to earn 6% when index funds average 12% per year over the
long run. But even the entire market carries risk. The return on index funds is not
12% every year, but can be -5% one year, 25% the next year, and so on. An
investor still faces substantially greater risk and volatility to get an overall return
that is higher than a predictable government security. The additional return is the
risk premium, which in this case is 6% (12% - 6%).
Measures of risk
There are two measures of risk. One is a measure of total risk (standard
deviation), the other a relative index of systematic or nondiversifiable risk (beta).
Beta measure is more relevant for the pricing of securities. Returns expected by
investors should logically be related to systematic as opposed to total risk.
Securities with higher systematic risk should have higher expected returns.
The "Capital Asset Pricing Model" (CAPM), postulates that assets with the same
risk should have the same expected rate of return.

44
That is, the prices of assets in the capital markets should adjust until equivalent risk
assets have identical expected returns. At this point, we say that the market is in an
"equilibrium" condition. Now consider the case of an investor who holds a
mixture of these two portfolios. Assume he invests a proportion X of his money in
the risky portfolio and (1 -X) in the riskless portfolio. What risk does he bear and
what return should he expect?
The risk of the composite portfolio is easily computed. The beta of a portfolio is
simply a weighted average of the component security betas, where the weights are
the portfolio proportions. Thus, the portfolio beta, β p, is a weighted average of the
market and risk-free rate betas, that is, an average of zero and one. The Capital
Asset Pricing Model (CAPM) is:
= RF + β p *( E(Rm)- RF)
This model says that the expected return on a portfolio should exceed the riskless
rate of return by an amount which is proportional to the portfolio beta. That is, the
relationship between return and risk should be linear. The model is often stated as:
E(rp) = p E(rm)
where E(rp) and E(rm) are the expected portfolio and market risk premiums,
formed by subtracting the risk-free rate from the rates of return. In this form the
model states that the expected risk premium for the investors portfolio is equal to
its beta value times the expected market risk premium.
Example: Risk premium
The risk-free interest rate is 6% and the ERM on the market with a relative risk
(beta) of 1.0 is 10%. Then the expected risk premium for holding the market
portfolio is just the difference between the 10% and the short-term interest rate of
6%, or 4%. Investors who hold the market portfolio expect to earn 10%, which is
4% greater than they could earn on a short-term market instrument for certain.
Expected Return for Different Levels of Portfolio Beta:
ra=rf+Ba(rm-rf)
Beta (β) Expected Return (ER)
0 = 6% + 0.0(10-6) =6%
0.5 = 6% + 0.5(10-6) =8%
1.0 = 6% + 1.0(10-6) =10%
1.5 = 6% + 1.5(10-6) =12%
For safe investments (β = 0), the model predicts that investors would expect to earn
the risk-free rate of interest. For a risky investment (β > 0) investors would expect
a ER proportional to the market sensitivity (β) of the stock. Thus, stocks with
lower-than-average market sensitivities would offer ER less than the expected
market return. Stocks with above-average values of beta would offer ER in excess
of the market.

45
 5. MANAGING PORTFOLIO RISK
Portfolio management can be defined as ‘the process of selecting a bunch of
securities that provides the investing agency a maximum return for a given level of
risk or alternatively ensures minimum risk for a given level of return’. The
investors, through portfolio management, attempt to maximize their expected
return consistent with individually acceptable portfolio risk.
Portfolio management thus refers to investment of funds in such combination of
different securities in which the total risk of portfolio is minimized while expecting
maximum return from it. As returns and prices of all securities do not move exactly
together, variability in one security will be offset by the reverse variability in some
other security. Ultimately, the overall risk of the investor will be less affected.
5.1 Steps involved in Portfolio Management Process
Portfolio management involves complex process which the following steps to be
followed carefully.
1. Identification of objectives and constraints.
2. Selection of the asset mix.
3. Formulation of portfolio strategy
4. Security analysis
5. Portfolio execution
6. Portfolio revision
7. Portfolio evaluation.
Now each of these steps can be discussed in detail.
5.1.1 Identification of objectives and constraints.
The primary step in the portfolio management process is to identify the limitations
and objectives. The portfolio management should focus on the objectives and
constraints of an investor in first place. The objective of an Investor may be
income with minimum amount of risk, capital appreciation or for future
provisions. The relative importance of these objectives should be clearly defined.
- Diversification
Diversification are investment plans aimed at reducing overall risk by investing in
securities and investments that are not subject to similar risks such that when one
group of assets face a down turn the other group will form a buffer against business
failure. The risk of investing in a single risky security, such as a stock or corporate
bond, is very high due to the company-specific risks e.g. the company could go
bankrupt, and the investor could lose the entire value of the investment.

46
Unsystematic risk can be eliminated by holding a broad portfolio of risky assets;
e.g., many different securities in many different industries. This is easy to
accomplish by owning a total market stock or bond index fund. Systematic risk is
the risk that remains after diversifying away unsystematic. A total stock or bond
market fund has systematic risk. This is risk impacting an entire asset class, such as
when rising real interest rates impact the entire bond market.
In an efficient market, assets with known systematic risks will be priced lower
and thereby compensate investors through higher expected returns. This expected
relationship only applies to systematic risks. There is no reward for incurring
unsystematic risk, and investors may therefore seek broad diversification without
reducing the expected return of their portfolio.
5.1.2 Selection of the asset mix.
The next major step in portfolio management process is identifying different assets
that can be included in portfolio in order to spread risk and minimize loss.
In this step, the relationship between securities has to be clearly specified. Portfolio
may contain the mix of Preference shares, equity shares, bonds etc. The percentage
of the mix depends upon the risk tolerance and investment limit of the investor.
- Asset allocation
After diversification, the next step in managing portfolio risk is asset allocation.
Asset allocation is the process of selecting an appropriate mixture of risk-free
assets and risky assets. The risky portion of the portfolio includes all risky assets
e.g. stocks, bonds, real estate, etc. A 30-day T-Bill is most commonly used to
represent the risk-free asset. Selecting the appropriate asset allocation (ratio of
risky assets to low-risk assets) is essential to designing a portfolio that matches the
investor's ability, willingness, and need to take risk.
5.1.3 Formulation of portfolio strategy
After certain asset mix is chosen, the next step in the portfolio management
process is formulation of an appropriate portfolio strategy. There are two choices
for the formulation of portfolio strategy, namely
i. an active portfolio strategy; and
ii. a passive portfolio strategy.
An active portfolio strategy attempts to earn a superior risk adjusted return by
adopting to market timing, switching from one sector to another sector according
to market condition, security selection or an combination of all of these. A passive
portfolio strategy on the other hand has a pre-determined level of exposure to risk.
The portfolio is broadly diversified and maintained strictly.
47
 5.1.4 Security analysis
In this step, an investor actively involves himself in selecting securities. Security
analysis requires the sources of information on the basis of which analysis is made.
Securities for the portfolio are analyzed taking into account of their price, possible
return, risks associated with it etc. As the return on investment is linked to the risk
associated with the security, security analysis helps to understand the nature and
extent of risk of a particular security in the market.
Security analysis involves both micro analysis and macro analysis. For example,
analyzing one script is micro analysis. On the other hand, macro analysis is the
analysis of market of securities. Fundamental analysis and technical analysis helps
to identify the securities that can be included in portfolio of an investor.
5.1.5 Portfolio execution
When selection of securities for investment is complete the execution of portfolio
plan takes the next stage in a portfolio management process. Portfolio execution is
related to buying and selling of specified securities in given amounts. As portfolio
execution has a bearing on investment results, it is considered one of the important
step in portfolio management.
5.1.6 Portfolio revision
Portfolio revision is one of the most important step in portfolio management. A
portfolio manager has to constantly monitor and review scripts according to the
market condition. Revision of portfolio includes adding or removing scripts,
shifting from one stock to another or from stocks to bonds and vice versa.
5.1.7 Portfolio performance evaluation.
Evaluating the performance of portfolio is another important step in portfolio
management. Portfolio manager has to assess the performance of portfolio over a
selected period of time. Performance evaluation includes assessing the relative
merits and demerits of portfolio, risk and return criteria, adherence of the portfolio
management to publicly stated investment objectives or some combination of these
factors. The quantitative measurement of actual return realized and the risk borne
by the portfolio over the period of investment is called for while evaluating risk
and return criteria. They are compared against the objective norms to assess the
relative performance of the portfolio.

48
 5.2 Otherwise equivalent (OE) benchmark portfolio
The first major goal of portfolio management is to derive rates of return that
equal or exceed the returns on a naively selected portfolio with equal risk. The
second goal is to attain complete diversification relative to a suitable benchmark.
We essentially compare the return of our owned and managed portfolio over a
particular period with that of the return of a benchmark portfolio.
The benchmark portfolio should represent a feasible investment alternative to your
portfolio that is being compared and evaluated. In reality, it is difficult to identify
such a benchmark portfolio. So, often, such a portfolio is known as an otherwise
equivalent (OE) benchmark portfolio. An OE benchmark portfolio requires that it
should have all characteristics of the portfolio that you own and manage.
Creating an Otherwise Equivalents (OE) portfolio
The names and weights of securities comprising the benchmark portfolio need to
be clearly delineated. It is investable as the option is available to forgo active
management and simply hold the benchmark. It is possible to calculate the return
on the benchmark on a reasonably frequent basis. It is reflective of current
investment opinions. The investor has current investment knowledge of the
securities that make up the benchmark. It is better to create the benchmark well in
advance, i.e., prior to the start of an evaluation period. If a benchmark does not
possess all of these properties, it is considered flawed.
5.3 Portfolio Risk
Specific types of portfolio risks
Portfolio theory makes an important distinction between two types of risks:
i) Unsystematic risk:
The measure of risk associated with a particular security; also known as
diversifiable risk. This risk can be mitigated by holding a diversified portfolio of
many different stocks in many different industries.
ii) Systematic risk (market risk):
Systematic risk is faced by all investors due to market volatility. This risk cannot
be diversified away. This is the type of risk most people are referring to when they
casually use the term "risk" when discussing investments.
Some additional risks faced by all investments include:
iii) Liquidity risk
The risk that an asset cannot be sold when desired or in sufficient quantities
because opportunities are limited. Treasury securities (with the exception of
inflation protected Treasury bonds) have the least liquidity risk.
iv) Political risk
The risk to an investment due to changes in the law or political regime. Potential
changes in tax law or changes in a country's structure of governance are sources of
political risk.
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 v) Inflation risk
Stocks, bonds and cash are all subject to the risk that one's investment will not
keep pace with inflation. This risk can be mitigated by investing in inflation-
protected Treasury bonds, such as TIPS or I-bonds.
vi) Financial risk
The risk due to the capital structure of a firm. Corporate debt magnifies financial
risk to a company's stocks and bonds.
vii) Management risk
Investors using actively managed funds are exposed to the risk that fund or
portfolio managers will under-perform benchmarks due to their management
decisions or style. Investors can avoid this risk by selecting passively-managed
index funds.
Bond investors also face the following major risks
viii) Interest rate risk
The risk associated with changes in asset price due to changes in interest rates. As
interest rates rise, prices on existing bonds decline and vice versa. Interest rate risk
is greater for bonds with longer maturities, and lower for bonds having short
maturities.
ix) Credit risk
This is the risk of default in loan repayments. Holders of corporate and municipal
bonds face this risk.
x) Call risk
The risk that a bond issuer, after a decline in interest rates, may redeem a bond
early, forcing the bond holder to find a replacement investment that may not pay as
well as the original bond.
xi) Reinvestment risk
The risk that earnings from current investments will not be reinvested at the same
rate of return as current investment yields. Coupon payments from a bond may
suffer reinvestment risk if they cannot be reinvested at the same rate as the bond's
yield.
xii) Currency risk
Investors in international stocks and bonds are also exposed to the risk caused from
changes in currency exchange rates. Investments in currencies other than the one in
which the investor purchases most goods and services are subject to currency risk.
xiii) Longevity risk
The risk an investor will outlive his/her money.
xiv) Shortfall risk
The risk that the portfolio will not provide sufficient returns to meet the investor's
goal.

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 5.4 Portfolio revision
A portfolio is a mix of securities selected from a universe of securities. Two
variables determine the composition of a portfolio; one is the securities included in
the portfolio and the other is the proportion of total funds invested in each security.
Portfolio revision involves changing the existing mix of securities. This may be
effected either by changing the securities currently included in the portfolio or by
altering the proportion of funds invested in the securities. The objective of
portfolio revision is to maximize the return for a given level of risk or minimize the
risk for a given level of return.
5.4.1 Constraints in portfolio revision
Portfolio revision or adjustment necessitates purchase and sale of securities. This
gives rise to problems which act as constraints in portfolio revision. These include:
i) Transaction cost
Buying and selling of securities involve transaction costs such as commission and
brokerage.
ii) Taxes
Tax is payable on the capital gains arising from sale of securities. Usually, long-
term capital gains are taxed at a lower rate than short-term capital gains. Currently,
this tax is not charged in Kenya.
iii) Statutory stipulations
The largest portfolios in every country are managed by investment companies and
mutual funds. These institutional investors are normally governed by certain
statutory stipulations regarding their investment activity.
iv) Intrinsic difficulty
Portfolio revision is a difficult and time consuming exercise. The methodology to
be followed for portfolio revision is also not clearly established.
5.4.2 Portfolio revision strategies
Two different strategies may be adopted for portfolio revision, namely an active
revision strategy and a passive revision strategy.
Active revision strategy
This involves frequent and sometimes substantial adjustments to the portfolio.
Investors who undertake active revision strategy believe that securities can be
mispriced at times giving an opportunity for earning excess returns through trading
in them. Moreover, they believe that different investors have divergent or
heterogeneous expectations regarding the risk and return of securities in the
market. The objective of active revision strategy is to beat the market.
Active portfolio revision is based on an analysis of the fundamental factors
affecting the economy, industry and company as also the technical factors like
demand and supply.

51
Consequently, the time, skill and resources required for implementing active
revision strategy will be much higher. The frequency of trading is likely to be
much higher under active revision strategy resulting in higher transaction costs.
Passive revision strategy,
It involves only minor and infrequent adjustment to the portfolio over time. The
practitioners of passive revision strategy believe in market efficiency and
homogeneity of expectation among investors. They find little incentive for actively
trading and revising portfolios periodically. Under passive revision strategy,
adjustment to the portfolio is carried out according to certain predetermined rules
and procedures designated as formula plans.
 Formula plans (rules for passive strategy revision)
These are mechanical revision techniques developed to enable the investors to
benefit from price fluctuations in the market by buying stocks when prices are low
and selling them when prices are high.
The prices of securities fluctuate and investors should buy when prices are low and
sell when prices are high. But investors are hesitant to buy when prices are low
either expecting that prices will fall further lower or fearing that prices would not
move upwards again. Similarly, when prices are high, investors hesitate to sell
because they feel that prices may rise further and they may be able to realize larger
profits.
The use of formula plans demands that the investor divide his investment funds
into two portfolios, one aggressive and the other conservative or defensive. The
formula plans specify predetermined rules for the transfer of funds from the
aggressive portfolio to the defensive portfolio and vice versa. These rules enable
the investor to automatically sell shares when their prices are rising and buy shares
when their prices are falling.
Formula plans for implementing passive portfolio revision
i) Constant shilling value plan:
In this plan, the investor constructs two portfolios, one aggressive, consisting of
equity shares and the other, defensive, consisting of bonds and debentures. The
purpose of this plan is to keep the value of the aggressive portfolio constant, i.e. at
the original amount invested in the aggressive portfolio. As share prices fluctuate,
the value of the aggressive portfolio keeps changing. When share prices are
increasing, the total value of the aggressive portfolio increases. The investor has to
sell some of the shares from his portfolio to bring down the total value of the
aggressive portfolio to the level of his original investment in it. The sale proceeds
will be invested in the defensive portfolio by buying bonds and debentures.

52
Similarly, when share prices are falling, the total value of the aggressive portfolio
would also decline. To keep the total value of the aggressive portfolio at its
original level, the investor has to buy some shares from the market to be included
in his portfolio. For this purpose, a part of the defensive portfolio will be liquidated
to raise the money needed to buy additional shares.
Under this plan, the investor is effectively transferring funds from the aggressive
portfolio to the defensive portfolio and thereby booking profit when share prices
are increasing. Funds are transferred from the defensive portfolio to the aggressive
portfolio when share prices are low.
Action points, or revision points, should be predetermined and should be chosen
carefully. The revision points have a significant effect on the returns of the
investor. For instance, the revision points may be predetermined as 10 per cent, 15
per cent, etc. above or below the original investment in the aggressive portfolio.
If the revision points are too close, the number of transactions would be more and
the transaction costs would increase reducing the benefits of revision. If the
revision points are set too far apart, it may not be possible to profit from the price
fluctuations occurring between these revision points.
Example: Constant shilling value plan of portfolio revision
Consider an investor who has Shs. 1,000,000 for investment. He decides to invest
Shs. 500,000 in an aggressive portfolio of equity shares and the remaining Shs.
500,000 in a defensive portfolio of bonds and debentures. He purchases 12,500
shares selling at Shs. 40 per share for his aggressive portfolio. The revision points
are fixed as 20 per cent above or below the original investment of Shs. 500,000.
After the construction of the portfolios, the share price will fluctuate. If the price
of the share increases to Shs. 45, the value of the aggressive portfolio increases to
Shs. 562,500 (12,500 * Shs. 45). Since the revision points are fixed to 20 per cent
above or below the original investment, the investor will act only when the value
of the aggressive portfolio increases to Shs. 600,000 or falls to Shs. 400,000.
Assume the price of the share increases to Shs. 50, the value of the aggressive
portfolio will be Shs. 625,000. The investor will sell shares worth Shs. 125,000
(2,500 * Shs. 50) and transfer the amount to the defensive portfolio by buying
bonds for Shs. 125,000. The value of the aggressive and defensive portfolios would
now be Shs. 500,000 and Shs. 625,000 respectively. The aggressive portfolio now
has only 10,000 shares valued at Shs. 50 per share.
Suppose that the share price falls to Shs. 40 per share. The value of the aggressive
portfolio would then be Shs. 400,000 (10.000 * Shs. 40) which is 20 per cent less
than the original investment. The investor now has to buy shares worth Shs.
100,000 (2,500* Rs. 40) to bring the value of the aggressive portfolio to its original
level of Shs. 500,000. The money required for buying the shares will be raised by
selling bonds from the defensive portfolio.
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The two portfolios now will have values of Shs. 500,000 (aggressive) and Shs.
525,000 (i.e. Shs. 625,000 – Shs. 100,000) (defensive), aggregating to Shs.
1,025,000. The investor started with Shs. 1,000,000 as investment in two
portfolios.
Thus, when the constant shilling value plan is being implemented, funds will be
transferred from one portfolio to the other, whenever the value of the aggressive
portfolio increases or declines to the predetermined levels.
No of Share Aggress % change Action
Shares price ive
12,500 40 500,000
12,500 45 562,000 (562000-500000) No action. Change is less than
=62,000/500000 20%
= 12.40%
12,500 50 625,000 (625000-500000) Sell shares worth Sh. 125,000
=125,000/500000 (2,500 shares @ Sh 50)
= 25% Buy bonds of Sh. 125,000
Result
Shares are worth Sh. 500,000
(10,000 shares *Sh50)
Bonds are worth Sh. 625,000
10,000 40 400,000 (400000-500000) Sell bonds worth Sh. 100,000
=(100,000)/500000 Buy shares worth Sh. 100,000
= (20%) (2,500 shares * Sh. 40)
Result
Shares are worth Sh. 500,000
(12,500 shares *Sh40)
Bonds are worth Sh. 525,000
ii) Constant Ratio plan:
This is a variation of the constant shilling value plan. Here again the investor
would construct two portfolios, one aggressive and the other defensive. The ratio
between the investments in aggressive portfolio and the defensive portfolio would
be predetermined such as 1:1 or 1.5:1 etc. The purpose of this plan is to keep this
ratio constant by readjusting the two portfolios when share prices fluctuate from
time to time. For this purpose, a revision point will also have to be predetermined.
Suppose the revision points are fixed as + 0.10. This means that when the ratio
between the values of the aggressive portfolio and the defensive portfolio moves
up by 0.10 points or moves down by 0.10 points, the portfolios would be adjusted
by transfer of funds from one to the other.

54
 Assume that an investor starts with Shs. 20,000, investing Shs. 10,000 each in the
aggressive portfolio and the defensive portfolio. The initial ratio is then 1:1. He has
predetermined the revision points as + 0.20. As share price increases the value of
the aggressive portfolio rises. When the value of the aggressive portfolio rises to
Shs. 12,000, the ratio becomes 1.2:1 (i.e.12,000 : 10,000). Shares worth Shs. 1,000
will be sold and the amount transferred to the defensive portfolio by buying bonds.
Now, the value of both the portfolios would be Shs. 11,000 and the ratio would
become 1:1.
Assume that the share prices are falling. The value of the aggressive portfolio
would start declining. If, for instance, the value declines to Shs. 8,500, the ratio
becomes 0.77:1 (i.e. Shs. 8,500 : Shs, 11,000). The ratio has declined by more than
0.20 points. The investor now has to make the value of both portfolios equal. He
has to buy shares worth Shs. 1,250 by selling bonds for an equivalent amount from
his defensive portfolio. Now the value of the aggressive portfolio increases by Shs.
1,250 and that of the defensive portfolio decreases by Shs. 1,250. The values of
both portfolios become Shs. 9,750 and the ratio becomes 1:1.
The adjustment of portfolios is done periodically in this manner.
Shares Aggress Ratio Action
ive
10,000 10,000 10000:10000
= 1:1
12,000 12,000 12000:10000 Sell shares worth Shs. 1,000, buy
= 1.2:1 bonds worth Shs. 1.000
Percentage change Result
= 2000/10000 = 0.2 Shares are worth Sh. 11,000 (12000-
1000)
Bonds are worth Sh. 11,000
(10000+1000)
11,000 8,500 8,500:10000 Sell bonds worth Shs. 1,250, buy
.85:1 shares worth Shs. 1.250
Percentage change Result
= 2500/11000 = -0.22 Shares are worth Sh. 9.750
(8,500+1250)
Bonds are worth Sh. 9,750
(11000-1,250)
iii) Dollar cost averaging:
All formula plans assume that stock prices fluctuate up and down in cycles. It this
cyclic movement in share prices to construct a portfolio at low cost.

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The plan stipulates that the investor invest a constant sum, such as Shs. 5,000, Shs.
10,000, etc. in a specified share or portfolio of shares regularly at periodical
intervals, such as a month regardless of the price of the shares at the time of
investment. This periodic investment is to be continued over a fairly long period to
cover a complete cycle of share price movements. If the plan is implemented over
a complete cycle of stock prices, the investor will obtain his shares at a lower
average cost per share than the average price prevailing in the market over the
period. This occurs because more shares would be purchased at lower prices than
at higher prices.
The dollar cost averaging is really a technique of building up a portfolio over a
period of time.
The plan does not envisage withdrawal of funds from the portfolio in between.
When a large portfolio has been built up over a complete cycle of share price
movements, the investor may switch over to one of the other formula plans for its
subsequent revision. The dollar cost averaging is specially suited to investors who
have periodic sums to invest.
All formula plans have their limitations. By their very nature they are inflexible.
Further, these plans do not indicate which securities from the portfolio are to be
sold and which securities are to be bought to be included in the portfolio. Only
active portfolio revision can provide answers to these questions.
Advantages of the formula plans
Formula plans offer the following advantages to the investors:
1. The investor obtains basic rules and regulations for purchase and sale
of securities.
2. The rules and regulations laid down by the formula plans are rigid and
they enable the investors to overcome emotions and make rational
decisions.
3. The investors can earn higher income from their portfolio by adopting
formula plans.
4. A course of action is determined in the light of the objectives of the
investors.
5. The investor is able to control buying and selling of securities.
6. Formula plans are helpful in making decisions on the timing of
investment.
Disadvantages of the formula plans
1. The formula plans do not help in the selection of security. The selection of
security is based on the fundamental or technical analysis.

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 2. Formula plans are highly rigid.
3. The formula plans can be applied for long periods, otherwise the transaction
cost will be high.
4. Formula plans do not help the investors make forecasts of market
movements. Without such forecasts best stocks cannot be identified.
5.5 Evaluation of portfolio performance
Portfolio evaluation is the last step in the process of portfolio management. It
refers to the evaluation of the performance of the portfolio.
It is essentially the process of comparing the return earned on a portfolio with the
return earned on one or more other portfolios or on a benchmark portfolio. It is the
stage when we examine the extent to which the objective has been achieved.
Portfolio evaluation comprises two functions, performance measurement and
performance evaluation. Performance measurement is an accounting function
which measures the return earned on a portfolio during the holding period or
investment period. Performance evaluation, on the other hand, addresses such
issues as whether the performance was superior or inferior, whether the
performance was due to skill or luck, etc.
5.5.1 Portfolio performance evaluation
While evaluating the performance of a portfolio, the return earned on the portfolio
has to be evaluated in the context of the risk associated with that portfolio. One
approach would be to group portfolios into equivalent risk classes and then
compare returns of portfolios within each risk category. An alternative approach
would be to specifically adjust the return for the riskiness of the portfolio by
developing risk adjusted return measures and use these for evaluating portfolios
across differing risk levels.
i) Need for evaluation
Investment may be carried out by individuals on their own but their funds may not
be large enough to create a well-diversified portfolio of securities. Moreover, the
time, skill and other resources at the disposal of individual investors may not be
sufficient to manage the portfolio professionally.
Institutional investors such as mutual funds and investment companies are better
equipped to create and manage well diversified portfolios in a professional fashion.
Hence, small investors may prefer to entrust their funds with mutual funds or
investment companies to have the benefits of their professional services and
thereby achieve maximum return with minimum risk and effort.
Whether the investment activity is carried out by individual investors themselves
or through mutual funds and investment companies, different situations arise where
evaluation of performance becomes imperative. These are discussed below:

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 ii) Situations where evaluation of performance is
imperative
- Self-Evaluation
Where individual investors undertake the investment activity on their own, the
investment decisions are taken by them. They construct and manage their own
portfolio of securities. This self-evaluation will enable him to improve his skills
and achieve better performance in future.
- Evaluation of portfolio managers
A mutual fund or investment company usually creates different portfolios with
different objectives aimed at different sets of investors.
Each such portfolio may be entrusted to different professional portfolio managers
who are responsible for the investment decisions regarding the portfolio entrusted
to each of them. In such a situation, the organization would like to evaluate the
performance of each portfolio so as to compare the performance of different
portfolio managers.
- Evaluation of mutual funds
There are many mutual funds and investment companies operating both in the
public sector as well as in the private sector. Investors and organizations desirous
of placing their funds with these mutual funds would like to know the comparative
performance of each so as to select the best mutual fund or investment company.
iii) Evaluation Perspective
A portfolio comprises several individual securities. In the building up of the
portfolio several transactions of purchase and sale of securities take place. Thus,
several transactions in several securities are needed to create and revise a portfolio
of securities. Hence, the evaluation may be carried out from different perspectives
or viewpoints such a transactions view, security view or portfolio view.
- Transaction view
An investor may attempt to evaluate every transaction of purchase and sale of
securities. Whenever a security is bought or sold, the transaction is evaluated as
regards its correctness and profitability.
- Security view
Each security included in the portfolio has been purchased at a particular price. At
the end of the holding period, the market price of the security may be higher or
lower than its cost price or purchase price. Further, during the holding period,
interest or dividend might have been received in respect of the security. Thus, it
may be possible to evaluate the profitability of holding each security separately.
- Portfolio view
A portfolio is a combination of carefully selected securities, combined in a specific
way so as to reduce the risk of investment to the minimum.

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An investor may attempt to evaluate the performance of the portfolio as a whole
without examining the performance of individual securities within the portfolio.
5.5.2 Measuring Portfolio Return
The first step in portfolio evaluation is calculation of the rate of return earned over
the holding period. Return may be defined to include changes in the value of the
portfolio over the holding period plus any income earned over the period.
However, in the case of mutual funds, during the holding period, cash inflows into
the fund and cash withdrawals from the fund may occur.
a) Investment return using the dividends model
The return on the investor's portfolio, designated Rp, is given by:
Rp = Dp -∆ Vp
Vp
where
D= dividends received
∆ Vp =change in portfolio value during the interval (Capital Gains)
Vp = market value of the portfolio at the beginning of the period
The formula assumes
- No capital inflows during the measurement period. Otherwise the calculation
would have to be modified to reflect the increased investment base.
- That any distributions occur at the end of the period, or that distributions are
held in the form of cash until period end.
If the distributions were invested prior to the end of the interval, the
calculation would have to be modified to consider gains or losses on the
amount reinvested. Thus, given the beginning and ending portfolio values
and distributions received, we can measure the investor's return.
b) Investment return using arithmetic average and
geometric average.
To measure the average return over a series of measurement intervals, two
calculations are commonly used, the arithmetic average and the geometric average
returns.
i) Arithmetic average
The arithmetic return measures the average portfolio return realized during
successive 1-year periods. It is simply any unweighted average of the annual
returns.
To illustrate the calculations, consider a portfolio with successive annual returns of
-0.084, 0.040, and 0.143 designated as R1, R2, and R3. The arithmetic average is,
(R1+R2+R3) /3 or (-.084+.04+.143)/3. = 3.3 percent per year.

59
 ii) Geometric average
The geometric average measures the compounded rate of growth of the portfolio
over the 3-year period. The average is obtained by taking a "geometric" average of
the three annual returns; that is,
= {[(1+ R1)(1 + R2) (1+ R3)] 3 - 1.0
= {[(1-0.084)(1 + 0.040) (1+ 0.143)] 3 - 1.0.
= {(.916)(1.04)(1.143)]3 -1
= (1.089)(1.089)(1.089) -1
= 1.29-1
The resulting growth rate for the portfolio is 2.9% per annum compounded
annually, for a total 3-year return of 8.9% (2.9%*3).
The formula for calculating the same is:
gn = (1+rc)1/n -1
where,
gn= Geometric Average Return
rc = cumulative return over the entire period
n = number of equal subset periods to average the return
The distinction between geometric average and the arithmetic average can be made
clear by an example.
Consider an asset which is purchased for Sh.1,000 at the beginning of year 1.
Suppose the assets price rises to Sh.2,000 at the end of the first year and then falls
back to Sh.1,000 by the end of the second year.
Year Asset price (Sh.) Change in price (Sh.) Arithmetic return
1 (Purchase) 1,000
2 2,000 +1,000 (1,000/1,000)= 100%
3 1,000 -1,000 (-1,000/2,000)= -50%
Arithmetic
average rate of = (100%-50%)/2 =
return 25%
The arithmetic average rate of return is the average of +100% and -50%, or +25%.
But an asset purchased for Sh.1,000 and having a value of Sh1,000 two years later
did not 'earn 25%; it clearly earned a zero return.
The arithmetic average of successive one-period returns is obviously not equal to
the true rate of return. The true rate of return is given by the geometric mean return
defined above; that is,
[(2.0) (0.5)] -1.0 = 0.

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The geometric mean of two numbers, say 2 and 8, is just the square root of their
product, that is, √2 ∗ 8 which is 4. As another example, the geometric mean of the
three numbers 4, 1, and 1/32 is the cube root of their product (1/8), which is 1/2,
that is, √4 ∗ 1 ∗ 1/32 .
A geometric mean is often used when comparing different items. For example, the
geometric mean can give a meaningful "average" to compare two companies which
are each rated at 0 to 5 for their environmental sustainability, and are rated at 0 to
100 for their financial viability.
c) Holding Period Return/Yield (HPR)
The one period rate of return, r, for a mutual fund may be defined as the change in
the per unit net asset value (NAV), plus its per unit cash disbursements (D) and per
unit capital gains disbursements (C) such as bonus shares. It may be calculated as:
Rp = [(NAVt- NAVi-1) + Dt + Ct]/ NAVi-1
Where
NAVt = NAV per unit at the end of the holding period.
NAVi-1= NAV per unit at the beginning of the holding period.
Dt = Cash disbursements per unit during the holding period.
Ct = Capital gains disbursements per unit during the holding period.
This formula gives the holding period yield or rate of return earned on a portfolio.
This may be expressed as a percentage.
The total return received from holding an asset or portfolio of assets over a period
of time, generally expressed as a percentage. Holding period return/yield is
calculated on the basis of total returns from the asset or portfolio – i.e. income plus
changes in value. It is particularly useful for comparing returns between
investments held for different periods of time.
Holding Period Return (HPR) and annualized HPR for returns over multiple years
can be calculated as follows:
Holding Period Return = Income + (End of Period Value – Initial Value) / Initial
Value
Annualized HPR = {[(Income + (End of Period Value – Initial Value)] / Initial
Value+ 1}1/t – 1
where t = number of years.
Returns for regular time periods such as quarters or years can be converted to a
holding period return through the following formula:
(1 + HPR) = (1 + r1) x (1 + r2) x (1 + r3) x (1 + r4) where r1, r2, r3and r4are periodic
returns.
Thus, HPR = [(1 + r1) x (1 + r2) x (1 + r3) x (1 + r4)] – 1

61
Example 1: Calculating holding period return
What is the HPR for an investor who bought a stock a year ago at Shs.500 and
received Shs.50 in dividends over the year, if the stock is now trading at Shs.600?
HPR = [50 + (600 – 500)] / 500 = 30%
Example 2: Calculating holding period return
Which investment performed better? Mutual Fund X that was held for three years,
during which it appreciated from Shs.1,000 to Shs.1,500 and received income of
Shs.50, or Mutual Fund B that went from Shs.2,000 to Shs.3,200 and received
income of Shs.100 over four years?
HPR for Fund X = [50 + (1,500 – 1,000)] / 1,000 = 55%
HPR for Fund B = [100 + (3,200 – 2,000)] / 2,000 = 65%
Note that Fund B had the higher HPR, but it was held for four years, as opposed to
the three years for which Fund X was held. Since the time periods are different,
this requires annualized HPR to be calculated, as shown below.
Example 3. Calculation of annualized HPR:
Annualized HPR for Fund X = (0.55 + 1)1/3 – 1 = 15.73%
Annualized HPR for Fund B = (0.65 + 1)1/4 – 1 = 13.34%
Thus, despite having the lower HPR, Fund X was clearly the superior investment.
Example 4. Your stock portfolio had the following returns in the four quarters of
a given year: +8%, -5%, +6%, +4%. How did it compare against the benchmark
index, which had total returns of 12% over the year?
HPR for the portfolio = [(1 + 0.08)(1 – 0.05)(1 + 0.06)(1 + 0.04)] – 1 = 13.1%
Your portfolio therefore outperformed the index by more than a percentage point
(however, the risk of the portfolio should also be compared to that of the index to
evaluate if the added return was generated by taking significantly higher risk).
d) Point-to-point or absolute return
In calculating the point-to-point or absolute return, the holding time does not play a
role.
Illustration: Calculating point-to-point return
So if your initial NAV was Shs.2,000 and now after 3 years, it is Shs.3,000, you
can calculate the point-to-point return using the formula;
Absolute return = (current NAV - initial NAV)/ initial NAV x 100
= [(Shs. 3,000 – Shs. 2,000)/2,000]*100 = 50%
e) Simple annualised return /effective annual yield
To annualise the return generated when holding period is less than 12 months. The
formula is:
((1 + Absolute Rate of Return) ^ (365/number of days)) – 1

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Illustration: Calculating simple annualised return /effective annual yield
The NAV of Shs. 2,000 may shoot to Shs. 2,500 in 7 months, i.e., 210 days. The
absolute return in this case is 25 per cent [(2,500-2,000)/2000]*100] over 7
months, i.e., 0.25
So it becomes
=((1 + 0.25) ^ (365/210)) - 1
=47.38 per cent
5.6 Ratios used in performance measures
5.6.1 The Sharpe Ratio
The Sharpe ratio measures the degree to which a portfolio is able to yield a return
in excess of the risk-free return to cash, per unit of risk. It is the simplest risk-
adjusted performance measure is the Sharpe ratio, used by Sharpe (1966) to
evaluate mutual fund performance. The Sharpe ratio helps investors evaluate the
performance of their portfolio over time as measured against another portfolio or
the market or the otherwise equivalent (OE) benchmark.
The ratio uses a simple formula, although an investor must calculate the inputs to
the formula. The Sharpe ratio is easily calculated using yearly data, or other time
periods such as monthly or daily information.
The higher a portfolio's Sharpe ratio, the more beneficial its returns have been
historically, compared to its degree of investment risk. And the lower the ratio,
the worst the performance.
If we were to graph expected excess return against risk, measured by the
“volatility,” or standard deviation of the excess return, the Sharpe ratio would be
the slope of a line from the origin through the point for portfolio p. Any fixed
portfolio that combines the fund with cash holdings would plot on the same line as
the portfolio Rp itself.
The Sharpe ratio is traditionally thought to make the most sense when applied to an
investor’s total portfolio, as opposed to any particular fund that represents only a
portion of the investor’s portfolio. The assumption is that what the investor really
cares about is the volatility of his or her total portfolio, and various components of
the portfolio combine to determine that via diversification, depending on the
correlations among the various components.

63
 1) Calculating the Sharpe Ratio
Example 1
Suppose the asset has a market return 17% and a risk-free rate of 2% (that is, an
expected return of 15% in excess of the risk free rate). We typically do not know if
the asset will have this return; suppose we assess the risk of the asset, defined as
standard deviation of the asset's excess return, as 10%. The risk-free return is
constant. Then the Sharpe ratio (using the old definition) will be
Sharpe ratio = Ra-Rf
αa
Where Ra is the return on the asset, Rf is the risk free rate of return and αa is the
standard deviation of the asset's excess return.
= (17% -2%)/10%
= 1.5
Example 2
Suppose that the investor currently has Sh.250,000 invested in a portfolio with an
expected return of 12% and a volatility of 10%. The efficient (tangent) portfolio
has an expected return of 17% and a volatility of 12%. The risk-free rate of interest
is 5%. The Sharpe ratio is:
= (12% -5%)/10%
= 7%
2) Weaknesses and strengths of the Sharpe Ratio
If applied to a single fund in isolation, the Sharpe ratio ignores the correlation of
the fund with the other investments in the portfolio, and so it may not correspond
in any meaningful way to the desirability of the fund as an investment.
If the Sharpe ratio of a fund is higher than that of the investor’s total investment
portfolio, we may still be able to conclude that the investor should be interested in
the fund. However, if it is lower, we cannot draw any conclusions without knowing
about the correlations.
The Sharpe ratio may also be inappropriate when returns are highly nonnormal.
Furthermore, if the returns distributions are highly skewed, such as when options
may be traded, the Sharpe ratio can be misleading.
Despite these limitations, the Sharpe ratio is used in practice as a measure of
portfolio performance. The ratio remains important in empirical asset pricing as
well, for it has a number of interesting properties whose descriptions are beyond
the scope of this review. Sharpe (1992) provides an overview and retrospective.
Another complaint is that this ratio relies on the notion that risk equals volatility
and that volatility is bad. Simple logic will tell you that the more you reduce
volatility, the less likely you are to be able to capture higher returns.

64
But the bigger problem for the Sharpe ratio is that it treats all volatility the same.
Basically, the ratio penalizes strategies that have upside volatility (i.e., big positive
returns), but those that developed other risk adjusted ratios just don’t think big
positive returns should be viewed as a negative thing.
Advantage of the Sharpe ratio
The Sharpe ratio has as its principal advantage that it is directly computable from
any observed series of returns without need for additional information surrounding
the source of profitability.
The accuracy of Sharpe ratio estimators hinges on the statistical properties of
returns, and these properties can vary considerably among strategies, portfolios,
and over time.
The Sharpe ratio can also be "gamed" by hedge funds or portfolio managers
seeking to boost their apparent risk-adjusted returns history. This can be done by:
 Lengthening the measurement interval: This will result in a lower estimate
of volatility. For example, the annualized standard deviation of daily returns
is generally higher than of weekly returns, which is, in turn, higher than of
monthly returns.
 Compounding the monthly returns but calculating the standard deviation
from the not compounded monthly returns.
 Writing out-of-the-money puts and calls on a portfolio: This strategy can
potentially increase the return by collecting the option premium without
paying off for several years. Strategies that involve taking on default risk,
liquidity risk, or other forms of catastrophe risk have the same ability to
report an upwardly biased Sharpe ratio. (An example is the Sharpe ratios of
market-neutral hedge funds before and after the 1998 liquidity crisis.)
 Smoothing of returns: Using certain derivative structures, infrequent
marking to market of illiquid assets, or using pricing models that understate
monthly gains or losses can reduce reported volatility.
 Eliminating extreme returns: Because such returns increase the reported
standard deviation of a hedge fund, a manager may chose to attempt to
eliminate the best and the worst monthly returns each year to reduce the
standard deviation.

65
 5.6.2 The Sharpe’s single-index model (SIM)
The Sharpe’s single-index model is a simple asset pricing model to measure both
the risk and the return of a stock. Mathematically the SIM is expressed as:
rit - rf = α1 + β1 ( rmt - rf) + εit
εit ~ N(0,σi)
where:
rit is return to stock i in period t
rf is the risk free rate (i.e. the interest rate on treasury bills)
rmt is the return to the market portfolio in period t
αi is the stock's alpha, or abnormal return
βi is the stocks's beta, or responsiveness to the market return
Note that rit - rf is called the excess return on the stock, rmt - rf the excess return on
the market εit are the residual (random) returns, which are assumed independent
normally distributed with mean zero and standard deviation σi
These equations show that the stock return is influenced by the market (beta), has a
firm specific expected value (alpha) and firm-specific unexpected component
(residual). Each stock's performance is in relation to the performance of a market
index. Security analysts often use the SIM for such functions as computing stock
betas, evaluating stock selection skills, and conducting event studies.
Assumptions of the Single-Index-Model
The single-index model assumes that there is only 1 macroeconomic factor that
causes the systematic risk affecting all stock returns and this factor can be
represented by the rate of return on a market index, such as the S&P 500.
The single-index model assumes that once the market return is subtracted out the
remaining returns are uncorrelated:
E (( Ri,t – βimt)(Rk,t – βkmt) = 0
which gives
Cov(Ri, Rk) = βiβkσ2
This is not really true, but it provides a simple model.
5.6.3 Jensen’s Alpha
Jensen's alpha (or Jensen's Performance Index, ex-post alpha) is used to
determine the abnormal return of a security or portfolio of securities over the
theoretical expected return. It is a version of the standard alpha based on a
theoretical performance index instead of a market index.
If an asset's return is even higher than the risk adjusted return, that asset is
said to have "positive alpha" or "abnormal returns". Investors are constantly
seeking investments that have higher alpha.

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Intercept, αJp
Alpha is perhaps the most well-known of the classical measures of investment
performance. The most convenient way to define Jensen’s alphas is as the
intercept, αJp, in the following time series regression:
rp,t+1=αJp+βprm,t+1+upt+1,
where
rp,t+1 is the return of the fund in excess of a short term “cash” instrument. Using the
fact that the expected value of the regression error is zero, we see how Jensen’s
alpha represents the difference between the expected return of the fund and that of
its OE portfolio strategy:
αJp=E{rp}−βpE{rm}=E{Rp}−[βpE{Rm}+(1−βp)Rf].
The second line expresses the alpha explicitly in terms of the expected returns and
portfolio weights that define the OE portfolio strategy. The OE portfolio has
weight βp in the market index with return Rm, and weight (1−βp) in the risk-free
asset or cash, with return Rf.
Alpha has some disadvantages. For example, alpha does not control for
nonsystematic sources of risk that could matter to investors.
Example 1: Jensen's Measure Calculation
Assuming the CAPM is correct, Jensen's alpha is calculated using the following
four variables:
R(i) = the realized return of the portfolio or investment
R(m) = the realized return of the appropriate market index
R(f) = the risk-free rate of return for the time period
β = the beta of the portfolio of investment with respect to the chosen market index
Using these variables, the formula for Jensen's alpha is:
Alpha = R(i) – [R(f) + β x {R(m) - R(f)}]
Assume a mutual fund realized a return of 15% last year. The appropriate market
index for this fund returned 12%. The beta of the fund versus that same index is
1.2 and the risk-free rate is 3%. The fund's alpha is calculated as:
Alpha = 15% - [3% + 1.2 x {12% - 3%}] = 15% - 13.8% = 1.2%.
Given a beta of 1.2, the mutual fund is expected to be riskier than the index, and
thus earn more.
A positive alpha in this example shows that the mutual fund manager earned more
than enough return to be compensated for the risk he took over the course of the
year.
If the mutual fund only returned 13%, the calculated alpha would be -0.8%
calculated as:
Alpha = 13% - [3% + 1.2 x {12% - 3%}] = 13% - 13.8% = -0.8%.
With a negative alpha, the mutual fund manager would not have earned enough
return given the amount of risk he was taking.
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Example 2: Jensen's Measure Calculation
Three funds, Fund A, Fund B and Fund C in a portfolio generated 14%, 17% and
22% respectively in 2016. The market index for the fund was 12% during the same
year and had a beta value of 1.4. The three funds’ beta values were 1.3, 1 and 1.5
respectively. The risk-free rate is 3%. Rank the funds using Jensen's Alpha
Measure.
Fund Return Beta Formula Jensen’s Alpha
= R(i) – [R(f) + β x {R(m) - R(f)}]
A 14% 1.3 =14% -[3% + 1.4 x {12% – 3%}] -1.6%
B 16% 1.0 =16% -[3% + 1.4 x {12% – 3%}] 0.4%
C 22% 1.5 =22% -[3% + 1.4 x {12% – 3%}] 9.4%
Market 12% 1.4
Risk free 3%
Given a market beta of 1.4, the mutual fund C is expected to be riskier than the
index, and thus earn more and Fund B is less riskier than the market and earns less.
A positive alpha for Funds B and C show that the mutual fund manager earned
more than enough return to be compensated for the risk he took over the course of
the year. The negative alpha of -1.6% by Fund A shows the mutual fund manager
would not have earned enough return given the amount of risk he was taking.
Alpha is used in finance to represent two things:
1. A measure of performance on a risk-adjusted basis.
Alpha, often considered the active return on an investment, gauges the
performance of an investment against a market index used as a benchmark, since
they are often considered to represent the market’s movement as a whole. The
excess returns of a fund relative to the return of a benchmark index is the fund's
alpha.
2. The abnormal rate of return on a security or portfolio in excess of
what would be predicted by an equilibrium model like the capital
asset pricing model (CAPM).
In this context, alpha is often known as the “Jensen index.”
5.6.4 Treynor ratio
The Treynor ratio, developed by Jack Treynor in 1965, is a measure of the return
on a portfolio in excess of the return on a risk-free investment in relation to
systematic risk. It is similar to the Sharpe ratio except that it uses systematic risk,
or beta, as a measure of volatility, rather than standard deviation.
Calculation of the Treynor ratio
Like the Sharpe ratio, the Treynor ratio uses the excess return, which is the
difference between the return on the portfolio in question and the return on a risk-
free investment. This is then divided by the portfolio’s systematic risk:
Treynor ratio = Rp – (Rf ßp)
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  Return on portfolio, Rp .
 Return on a risk-free investment, Rf .
 Excess return, Rp - Rf.
 Portfolio volatility, ßp.
Example: Treynor ratio
A company wants to monitor the performance of its investment manager who has
produced returns of 20%, by making an adjustment for the level of risk he has
taken on. The beta of the portfolio is 1.4. The risk-free rate of return is 5%:
T = Rp - Rf ßp
T = 20 – (5*1.4) = 13 %
So, whilst the portfolio produced a good return, much of that was attributable to a
relatively high level of risk rather than superior investment decisions.
Limitations of Treynor ratio
It does not allow for unsystematic risk.
5.6.5 The Treynor–Black Appraisal Ratio
The model tries to determine the optimal combination of passively and actively
managed assets in an investment portfolio. When determining the optimal
allocation of assets, the model focuses primarily on securities' systematic and
unsystematic risk.
In essence the optimal portfolio consists of two parts:
- a passively invested index fund containing all securities in proportion to
their market value and
- an 'active portfolio' containing the securities for which the investor has made
a prediction about alpha.
In the active portfolio the weight of each stock is proportional to the alpha value
divided by the variance of the residual risk.
The model focuses less on the Beta of a security and more on its unsystematic risk.
The more unsystematic risk a security has, the less weight it is given in the
Treynor-Black model.
As a result of this tendency, the Treynor-Black model is said to favor low-return,
low-risk securities over those with higher return and higher risk.
The Model
Assume that the risk free rate is RF and the expected market return is RM with
standard deviation σM. There are N securities that have been analyzed and are
thought to be mispriced, with expected returns given by:
ri = Rf +βi (RM-RF) + σi + εi
where the random terms εi are normally distributed with mean 0, standard
deviation σi, and are mutually uncorrelated. (This is the so-called Diagonal Model
of Stock Returns, or Single-index model due to William F. Sharpe).

69
Then it was shown by Treynor and Black that the active portfolio A is constructed
using the weights
Wi = αi / σ2i
∑Nj=1 αj / σ2j
(Note that if an alpha is negative the corresponding portfolio weight will also be
negative, i.e. the active portfolio is in general a long-short portfolio).
The overall risky portfolio for the investor consists of a fraction wA invested in the
active portfolio and the remainder (i.e. wM=1-wA) invested in the market portfolio.
This fraction is found as follows:
wA = w0
1+(1-βA) w0

w0 = αA / σ2A
(RM-RF)/ σ2M

αA = ∑wiαi
βA = ∑wi βi
σ2A = ∑w2i σ2i
where the alpha, α, beta and residual risk of A are found using the previously
computed weights wi in the obvious way. Black and Treynor (1973) studied a
situation where security selection ability implies expectations of nonzero Jensen’s
alphas for individual securities, or equivalently, the benchmark market return index
is not mean–variance efficient given those expectations. They derive the mean–
variance optimal portfolio in this case and show that the optimal deviations from
the benchmark holdings for each security depend on the “Appraisal Ratio”:
An Example
Consider a portfolio that can be constructed from the following four assets:
Asset (i) Annual Return (ri) Annual Risk (σi) Beta (βi)

1 20% 30% 0
2 30% 45% 2
3 15% 15% 0.5
4 12% 12% 0.5
Market 10% 20%
Risk free rate 5%

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The measure of total return for the ith asset is its expected annual return, ri, and the
measure of total risk is the annual standard deviation of total return, σi. In order to
simplify the example, all systematic risk is assumed to be captured by a single
systematic risk factor that is referred to as the market.
The amount of systematic risk contained in the ith asset is given by its beta, βi. The
only other information that is needed to apply the Treynor-Black model to these
four assets are the risk-free rate of return (rf), which is taken to be 5% per annum;
the market rate of return (rm), which is taken to be 10% per annum; and the market
risk (σm), which is taken to be 20% per annum.
The four assets differ. The first asset has both high risk and high return, but is
uncorrelated with the market (β1=0). Managers often view such an asset as an ideal
addition to a portfolio because its lack of correlation with other assets helps to
diversify risk. The second asset has a beta of two, characteristic of a highly
leveraged asset. Its risk and return are even higher than the first asset, but in the
same overall ratio.
The final two assets have both lower risk and return than the first two assets,
although the ratio of return to risk appears higher than that of the first two assets.
Both have a modest beta of 0.5 and the latter of the two has both lower risk and
return.
For the ith asset, alpha (αi) and the square of specific risk (αi /σ2(ei)) can be
computed directly from the information above using the following standard
formulas (and then substituting the appropriate market parameters):
αi = ri - (rm-rf)βi -rf
=20%–(10%-5%)0-5%
= 20% -(5%)0 – 5%
= 20%-0-5% = 15%
and
σ2(ei) = σi2 – σm2βi2
= (30%)2 – (20%)2(0)2
= 0.09 – (0.04) 0
= 0.09

Weight = (αi /σ2(ei))

= 15%/9%
= 1.67

Share = [(αiσ2(ei))/21.42]*100
= {1.67/21.42}*100
= 7.796%

71
Performing these substitutions and then computing the Treynor-Black weights (and
the share implied by them) generates the following table:
Asset Alpha Specific Risk2 Weight Share (allocation)
(i) (α i) (σ2(ei)) (αi /σ2(ei)) [(αiσ2(ei))/21.42]*100

1 15.00% 9.00% 1.67 7.78%

2 15.00% 4.25% 3.53 16.47%

3 7.50% 1.25% 6.00 28.01%

4 4.50% 0.44% 10.23 47.74%

Total 21.42 100.00%

Calculating alpha:
Asset (i) Calculation Alpha (α i)

1 = 20%-(10%-5%)0 -5% = 20%-(5%)0 – 5% 15.00%

2 = 30%-(10%-5%)2 -5% = 30%-(5%)2 – 5% 15.00%

3 = 15%-(10%-5%)0.5 -5% = 15%-(5%)0.5 – 5% 7.50%

4 = 12%-(10%-5%)0.5 -5% = 12%-(5%)0.5 – 5% 4.50%

Calculating specific risk
Asset (i) Calculation Specific Risk2 (σ2(ei))

1 (30%)2 – 0.04(0)2 = 0.09 – 0 9.00%

2 (45%)2 – 0.04(2)2 = 0.2025 – 0.16 = 0.0425 4.25%

3 (15%)2 – 0.04(0.5)2 = 0.0225 – 0.01 1.25%

4 (12%)2 – 0.04(0.5)2 = 0.0144 – 0.01 0.44%

Notice that Asset 1, the great diversifier, receives the smallest weight in the
portfolio. Although its zero beta keeps its alpha high, it does nothing to lessen its
high risk, leaving it with a large amount of specific risk and a correspondingly
small share of 7.78%.
Asset 4 is the greatest beneficiary of the Treynor-Black model, even with the
lowest alpha, its very low level of specific risk makes it the favored holding.
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Except for those rare instances where high return is accompanied by low risk, the
Treynor-Black model tends to favor assets with low risk and low return. Its
aversion to high risk/high return assets tends to be greater than one would
intuitively think it should be.
The basic properties of the portfolios selected by the Treynor-Black model can be
seen from this example. First, the relative allocation among assets is independent
of the amount of money to be allocated among them because allocations are
expressed in terms of shares, not monetary amounts. Second, adding or removing
assets does not change the relative allocation among any of the existing or
remaining assets. A third important property is the stability of the model, its lack
of sensitivity to small changes in the parameters of the model.
5.6.6 The Treynor–Mazuy Market Timing Measure
The Treynor-Mazuy Measure is an absolute measure of performance. The
Treynor-Mazuy Measure gives the excess return obtained by the manager
which is not explained by his/her current risk positions.
The magnitude of the Treynor-Mazuy Measure depends on two variables: the
return of the fund and risk sensitivities variability. This indicator represents the
part of the mean return of the fund that cannot be explained by common factorial
risk exposure. It is a function of how good were the anticipations of the manager
concerning market factor evolutions.
Formula:
TMp,t = [ Et(Rp,t) – Rf] –{β̂p [ Et(Rm,t) – Rf]} + ̂p [ Et(Rm,t) – Rf]2}
where:
Et(Rp,t) is the annualized mean return on the fund considered over period;
Et(Rm,t) is the annualized mean return on the market portfolio considered over
period;
Rf is a proxy for the riskless rate;
ˆp is a function of the slope of the portfolio return function;
̂p is a parameter that depends on the convexity of the portfolio return function;
Two year data of weekly series is considered.
Example: Treynor-Mazuy Measure
The annualized mean return (Et(Rp,t)) on the fund considered over the period is
20%, the annualized mean return on the market portfolio E t(Rm,t) considered over
period is 18%, Rf is a proxy for the riskless rate is 10%, ˆp , a function of the slope
of the portfolio return function is 1.5; and ̂p, a parameter that depends on the
convexity of the portfolio return function is .02. Then TMp,t is calculated as:
TMp,t = [ 20% – 10%] –{1.5 [ 18% – 10%]} + .02 [ 18% – 10%]2}
= [10%]- {1.5*8%}+.02[82]
= 10% - 12% + 1.28% = -0.72%

73
 5.6.7 The Merton–Henriksson Market Timing Measure
The Merton-Henriksson Measure gives the excess return obtained by the
manager that cannot be replicated by a mix of options and market portfolio.
That represents the excess returns that have been economized by the manager
because of its market timing ability.
5.6.8 Formula: The Merton–Henriksson Market Timing Measure
HMp,t = [ Et(Rp,t) – Rf] –{β̂1,p [ Et(Rm,t) – Rf]} - β̂2,p Max [ 0, Rf - Et(Rm,t)]
Where:
Et(Rp,t) is the annualized mean return on the fund considered over period;
Et(Rm,t) is the annualized mean return on the market portfolio considered over
period;
Rf is a proxy for the riskless rate;
β̂1,p is a function of the slope of the portfolio return function;
β̂2,p is the cost of option saved by the manager.
Two year data of weekly series is considered.
Successful timing implies higher betas when the market subsequently goes up,
or lower betas when it goes down, leading to the convex relation.
5.6.9 Multibeta /multi-factor Models
A multi-factor model is a financial model that employs multiple factors in its
computations to explain market phenomena and/or equilibrium asset prices.
The multi-factor model can be used to explain either an individual security or a
portfolio of securities. It does so by comparing two or more factors to analyze
relationships between variables and the resulting performance. They are generally
extensions of the single-factor capital asset pricing model (CAPM).
Categories of Multi-Factor Models
Multi-factor models can be divided into three categories: macroeconomic models,
fundamental models and statistical models. Macroeconomic models compare a
security's return to such factors as employment, inflation and interest.
Fundamental models analyze the relationship between a security's return and its
underlying financials, such as earnings. Statistical models are used to compare the
returns of different securities based on the statistical performance of each security
in and of itself.
Beta
The beta of a security measures the systemic risk of the security in relation to the
overall market. A beta of 1 indicates that the security theoretically experiences the
same degree of volatility as the market and moves in tandem with the market.
A beta greater than 1 indicates the security is theoretically more volatile than the
market. Conversely, a beta less than 1 indicates the security is theoretically less
volatile than the market.

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Multibeta models arise when investors optimally hold combinations of a mean–
variance efficient portfolio and hedge portfolios for the other relevant risks. In this
case the otherwise equivalent (OE) portfolios are combinations of a mean–variance
efficient portfolio and the relevant hedge portfolios. The simplest performance
measures implied by multibeta models are straightforward generalizations of
Jensen’s alpha, estimated as the intercept in a multiple regression.
Multi-Factor Model Formula
Factors are compared using the following formula:
Ri = ai + _i(m) * Rm + _i(1) * F1 + _i(2) * F2 +...+_i(N) * FN + ei
Where:
Ri is the returns of security i
Rm is the market return
F(1, 2, 3 ... N) is each of the factors used
_ is the beta with respect to each factor including the market (m)
e is the error term
a is the intercept
5.6.10 Weight-Based Performance Measures
In a returns-based measure the return earned by the fund is compared with the
return on the OE benchmark over the evaluation period. The OE benchmark is
designed to control for risk, style, investment constraints and other factors, and the
manager who returns more than the benchmark has a positive “alpha.”
One strength of returns-based methodologies is their minimal information
requirements. One needs only returns on the managed portfolio and the OE
benchmark. However, this ignores potentially useful information that is sometimes
available in practice: the composition of the managed portfolio. In a weight-based
measure the manager’s choices are directly analyzed for evidence of superior
ability. A manager who increases the fund’s exposure to a security or asset class
before it performs well, or who anticipates and avoids losers, is seen to have
investment ability.
The following equation is used:
Maxx = E{U(W0[Rf+xfr])|S},
where
Rf is the risk-free rate,
r is the vector of risky asset returns in excess of the risk-free rate,
W0 is the initial wealth,
x is the vector of portfolio weights on the risky assets, and
S is the manager’s private information signal, available at time 0.

75
Private information, by definition, is correlated with the future excess returns, r. If
returns are conditionally normal given S, and the investor has nonincreasing
absolute risk aversion, the first and second-order conditions for the maximization
imply that
E{x(S)f[r−E(r)]}=Cov{x(S)tr}>0,
where
x(S) is the optimal weight vector and
r−E(r) are the unexpected, or abnormal returns, from the perspective of an observer
without the signal.

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6 EFFICIENT MARKET HYPOTHESIS
6.1 Efficient market hypothesis
In a theoretical sense, markets are said to be efficient, if there is a free flow of
information and market absorbs this information fully and quickly. Such efficiency
will produce prices that are appropriate in terms of current knowledge, and
investors will be less likely to make unwise investments.
6.1.1 Assumptions of efficient market hypothesis
i) Information is free and quick to flow.
ii) All investors have the same access to information.
iii) Transaction costs, taxes and any bottlenecks are not there and not hampering
the free forces of market.
iv) Investors are rational and behave in a cost effective competitive manner for
optimization of returns.
v) Every investor has access to lending and borrowing at the same rate.
vi) Market prices absorb the market information quickly and the market
responds to new technology, new trends, changes in tastes, habits of
consumers etc., efficiently and quickly.
6.1.2 Forms of Efficient Market Hypothesis
There are three forms of the Hypothesis, namely, weak form of EMH discussed
under Random Walk Theory, semi strong from and strong form. In the words of
Fama, efficient market is defined as the market where there are a large number of
rational profit maximisers actively competing with each trying to predict the future
market and where the current information is almost freely and equally available to
all participants.
(i) Weak form of EMH
In the Weak Form of EMH the past prices are already absorbed by the market and
the present prices move independently of the past. Prices move in a random
fashion, each move independent of the other. In the real world, the weak form of
market efficiency may exist, as prices do move in an independent manner as the
past prices are already absorbed by the market. However, market imperfections,
costs of information and blocks to the free flow of information may stand in the
way of free play of market forces. Speculators and groups of interested parties or
even brokers may manipulate the prices
(ii) Semi Strong Form of EMH
This form of EMH postulates that the market absorbs quickly and efficiently, the
price information and all publicly available information. Examples of this public
information are found in the financial reports, any material information affecting
the financial position, such as financial structure, liquidity, solvency etc. is also
found relevant and absorbed by the market in the price formation.

77
Some data and information that may be contradictory and biased information,
rumours etc. would also flow in as news affecting the market. Revision of data or
changes in conditions of the company also affect the price.
The semistrong form is empirically not well supported, but in many foreign
markets, the semi strong form is found to be applicable and markets quickly absorb
all published information. This is possible in those markets due to strict law
enforcement, but the market authorities, instantaneous display of all market
information through electronic media and investor awareness of their impact and
their quick absorption of the data. The revolution in informatics and
communication technologies has made it possible for the application of the
semistrong form of the EMH to these markets in developed countries.
(iii) Strong Form of EMH
Under this hypothesis markets are so perfect that all information including private
information, insider information and unpublished data, affecting the market are
absorbed in the stock prices. Any investor can then gain the same average returns,
whenever he enters the market. The information of all types is flashed to all
investors simultaneously and all players have the same information at the same
time. This means that only superior analysis and interpretation can give better
market returns. This is possible for inside traders, floor brokers and institutional
investors who have highly efficient market research component. The acumen with
which price movements can be forecast can only result in superior return and not
otherwise.
Studies made in developed markets have shown that strong form of efficient
market does not exist there also. Investors have not shown consistently higher
returns even with all the information available to them. It was also found that
average investor could do better by picking up securities in a random fashion.
(iv) Critique of EMH
Opinion is divided as to the validity of the EMH particularly in the strong form. In
weak form Random Walk hypothesis holds good, as per some studies. The semi
strong form has found less support from the empirical studies. The perfect markets
do not exist, as the stocks as a rule do not sell at the best price based on intrinsic
values. Many times, speculative fervor sentiment and expectations play a greater
role on the stock prices than the fundamental factors.
Similarly news does not spread evenly among all segments of the market and
among all investors. Institutional investors gain through market equity research and
through economies of scale and better expertise. But individual investors do not
gain by speedy spread of information and the absorption of the same by market.
6.2 Random Walk Theory
As per this theory, changes in stock prices are independent of each other. The
prices of today are independent of the past trends.
78
The present price is randomly determined and only information flow can influence
prices. As information is free and independent, the resulting prices are free and
independent. The equilibrium price of a stock is determined by demand and supply
forces, based on the available information. Quickly as the fresh information
becomes available, a new equilibrium point is reached and the resultant price is
thus independent of the past.
6.2.1 Assumption of Random Walk Theory
i) Market is supreme and no individual investor or group can influence it.
ii) Stock prices discount all information quickly.
iii) Markets are efficient and that the flow of information is free and unbiased.
iv) All investors have free access to the same information and nobody has
superior knowledge or expertise.
v) Market quickly adjusts itself to any deviation from equilibrium level due to
the operation of free forces of demand and supply.
vi) Market prices change only on information relating to the fundamentals,
when the equilibrium level itself may shift.
vii) These prices move in an independent fashion, with undue pressures or
manipulation.
viii) Nobody has better knowledge or insider information.
ix) Investors behave in a rational manner and demand and supply forces are the
result of rational investment decisions.
x) Institutional investors or any major fund managers have to follow the
market and market cannot be influenced by them.
xi) A large number of buyers & sellers and perfect market conditions of
competition will prevail;

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7 MODERN PORTFOLIO THEORIES AND TECHNIQUES
7.1 Modern Portfolio Theory (MPT)
Modern portfolio theory (MPT), or mean-variance analysis, is a mathematical
framework for assembling a portfolio of assets such that the expected return is
maximized for a given level of risk, defined as variance. Its key insight is that an
asset's risk and return should not be assessed by itself, but by how it contributes to
a portfolio's overall risk and return. It is a theory on how risk-averse investors can
construct portfolios to optimize or maximize expected return based on a given
level of market risk, emphasizing that risk is an inherent part of higher reward.
According to the theory, it's possible to construct an "efficient frontier" of optimal
portfolios offering the maximum possible expected return for a given level of risk.
Likewise, given a desired level of expected return, an investor can construct a
portfolio with the lowest possible risk. Based on statistical measures such as
variance and correlation, an individual investment's return is less important than
how the investment behaves in the context of the entire portfolio.
7.1.1 Assumptions of Markowitz theory
i) Investors consider each investment alternative as being represented by a
probability distribution of expected returns over some holding period.
ii) Investors maximize one-period expected utility and their utility curves
demonstrate diminishing marginal utility of wealth.
iii) Investors estimate risk on basis of variability of expected returns.
iv) Investors base decisions solely on expected return and risk.
v) Investors prefer higher returns to lower risk and lower risk for the same level
of return
7.1.2 Portfolio Risk and Expected Return
MPT makes the assumption that investors are risk-averse, meaning they prefer a
less risky portfolio to a riskier one for a given level of return. This implies than an
investor will take on more risk only if he or she is expecting more reward. MPT
further makes an assumption that all investors will have the same expectations and
make the same choices given a particular set of circumstances. The assumption of
homogeneous expectations means if investors are shown several investment plans
with different returns at a particular risk, investors will choose the plan that boasts
the highest return. Similarly, if investors are shown plans that have different risks
but the same returns, investors will choose the plan that has the lowest risk.
Example 1: Expected Return
The expected return of the portfolio is calculated as a weighted sum of the
individual assets' returns. If a portfolio contained four equally-weighted (i.e. 25%)
assets with expected returns of 4%, 6%, 10% and 14%, the portfolio's expected
return would be:

80
(4% x 25%) + (6% x 25%) + (10% x 25%) + (14% x 25%) = 8.5%
The portfolio's risk is a complicated function of the variances of each asset and the
correlations of each pair of assets. To calculate the risk of a four-asset portfolio, an
investor needs each of the four assets' variances and six correlation values, since
there are six possible two-asset combinations with four assets.
Because of the asset correlations, the total portfolio risk, or standard deviation, is
lower than what would be calculated by a weighted sum.
Example 2: Expected Return
Consider that you have Sh.300,000 in the following 4 stocks.
Security Amount Beta Xi Ri=Rf + βi(Rm-Rf)
A 50,000 0.75 50,000/300,000=0.16 (4%+(0.75(15%-4%))= 0.1225
7
B 100,000 1.10 0.333 0.1610
C 80,000 1.36 0.267 0.1896
D 70,000 1.88 0.233 0.2468
300,000 1.00
The risk free rate is 4% and the expected return on the market portfolio is 15%.
Using the capital asset pricing market, what is the expected return on the above
portfolio?
Solution:
Here
Rf =.04,
Rm =.15.
Βi denotes the beta coefficient of the stock i.
We calculate the beta coefficient βi for the portfolio and get the expected return on
the portfolio from the capital asset pricing model equation.
Here
βI = XA βA + XBβB + XCβC…XDβD
= 0.167(0.75)+0.333(1.1)+ 0.267(1.36) + 0.233(1.88) = 1.29
Capital asset pricing model equation is
Ri=Rf + βi(Rm-Rf)
=0.04+(1.29)(.15-.04),
=0.04+0.14.2
=0.182.
The expected return is 18.2%
Example 3: Expected Return
Consider an oil drilling venture. The expected payoff is Sh.12,000 and standard
deviation of return is 40%. The β of the asset is 0.8 that is relatively low. The risk
free rate is 20% and the expected return on the market portfolio is 70%. What is
the value of this share of the oil venture using the CAPM?
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Solution
We know that
P= Ԛ .
[1+{rf+ β (rm-rf)}]
Where
Q= Sh.12,000,
β=0.8
rf =20% or 0.20,
rM =70% or 0.70
Putting this value in the above equation we have:
P = 12000 .
[1+{0.2+ 0.8 (0.7-0.2)}]
P=Sh.7,500.
The value of the security is Sh.7,500
7.2 Efficient frontier
Markowitz described the "efficient frontier," a set of optimal portfolios that
provide the best expected returns for a defined risk level or the lowest risk level for
a defined expected return. Portfolios that fall outside the efficient frontier are
considered sub-optimal because they either carry too much risk relative to the
return or too little return relative to the risk.
Every possible combination of assets that exists can be plotted on a graph, with the
portfolio's risk on the X-axis and the expected return on the Y-axis. This plot
reveals the most desirable portfolios. For example, assume Portfolios A and B have
expected returns of 8.5% each and a standard deviation of 8% and 9.5%
respectively. Portfolio A would be deemed more "efficient" because it has the
same expected return but a lower risk.
It is possible to draw an upward sloping hyperbola to connect all of the most
efficient portfolios, and this is known as the efficient frontier. Investing in any
portfolio not on this curve is not desirable. Since the efficient frontier is curved,
rather than linear, a key finding of the concept was the benefit of diversification.
Optimal portfolios that comprise the efficient frontier tend to have a higher degree
of diversification than the sub-optimal ones, which are typically less diversified.
If a risk-free asset is also available, the opportunity set is larger, and its upper
boundary, the efficient frontier, is a straight line segment emanating from the
vertical axis at the value of the risk-free asset's return and tangent to the risky-
assets-only opportunity set.
All portfolios between the risk-free asset and the tangency portfolio are portfolios
composed of risk-free assets and the tangency portfolio, while all portfolios to the
right of the tangency portfolio are generated by borrowing at the risk-free rate and
investing the proceeds into the tangency portfolio.
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 Efficient Frontier.
The hyperbola is sometimes referred to as the 'Markowitz Bullet', and its upward
sloped portion is the efficient frontier if no risk-free asset is available. With a risk-
free asset, the straight line is the efficient frontier.
7.2.1 Limitations of the efficient frontier
The efficient frontier and modern portfolio theory have many assumptions that
may not properly represent reality. For example, one of the assumptions is that
asset returns follow a normal distribution. In reality, securities may experience
returns that are more than three standard deviations away from the mean more than
0.03% of the observed values. Consequently, asset returns are said to follow a
leptokurtic distribution, or heavy tailed distribution.
Additionally, Markowitz's theory assumes investors are rational and avoid risk
when possible, there are not large enough investors to influence market prices, and
investors have unlimited access to borrowing and lending money at the risk-free
interest rate. However, the market includes irrational and risk-seeking investors,
large market participants who could influence market prices, and investors do not
have unlimited access to borrowing and lending money.
7.2.2 Optimal Portfolio
According to Markowitz's theory, there is an optimal portfolio that could be
designed with a perfect balance between risk and return. The optimal portfolio
does not simply include securities with the highest potential returns or low-risk
securities. The optimal portfolio aims to balance securities with the greatest
potential returns with an acceptable degree of risk or securities with the lowest
degree of risk for a given level of potential return. The points on the plot of risk
versus expected returns where optimal portfolios lie is known as the efficient
frontier.
7.2.3 Selecting Investments
A risk-seeking investor who uses the efficient frontier to select investments would
select securities that lie on the right end of the efficient frontier.
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This end of the efficient frontier includes securities that are expected to have a high
degree of risk coupled with high potential returns, which is suitable for risk-
tolerant investors. Conversely, securities that lie on the left end of the efficient
frontier would be suitable for risk-averse investors.
i) The Capital market line
Capital market line (CML) is the tangent line drawn from the point of the risk-
free asset to the feasible region for risky assets. The tangency point M represents
the market portfolio, so named since all rational investors (minimum variance
criterion) should hold their risky assets in the same proportions as their weights in
the market portfolio.
Capital market line

Formula for calculating Capital market line

CML:E(rp) =rf – β[(E(rM)- rf] = rf +ρ[ σP/σM][E(rM) – rf]
The CML results from the combination of the market portfolio and the risk-free
asset (the point L). All points along the CML have superior risk-return profiles to
any portfolio on the efficient frontier, with the exception of the Market Portfolio,
the point on the efficient frontier to which the CML is the tangent. From a CML
perspective, the portfolio M is composed entirely of the risky asset, the market,
and has no holding of the risk free asset, i.e., money is neither invested in, nor
borrowed from the money market account. Points to the left of and above the CML
are infeasible, whereas points to the right/below are attainable but inefficient.
Addition of leverage (the point R) creates levered portfolios that are also on the
CML.
Capital market line, Sharpe ratio and alpha
All of the portfolios on the CML have the same Sharpe ratio as that of the market
portfolio, i.e.
[E(r) - rf]/σ = [E(rM) – rf]/ σM
In fact, the slope of the CML is the Sharpe ratio of the market portfolio.
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A stock picking rule of thumb is to buy assets whose Sharpe ratio will be above the
CML and sell those whose Sharpe ratio will be below. From the efficient market
hypothesis it follows that it's impossible to beat the market. Therefore, all
portfolios should have a Sharpe ratio less than or equal to the market's. In
consequence, if there is a portfolio whose Sharpe ratio will be bigger than the
market's then this portfolio has a higher return per unit of risk (i.e. the volatility σ),
which contradicts the efficient market hypothesis.
This abnormal extra return over the market's return at a given level of risk is what
is called the alpha.
ii) The capital allocation line (CAL)
Capital allocation line (CAL) is a graph created by investors to measure the risk
of risky and risk-free assets. The capital allocation line (CAL), also known as the
capital market link (CML), is a line created on a graph of all possible combinations
of risk-free and risky assets. The graph displays the return to be made by taking on
a certain level of risk.
Capital allocation line

Formula for calculating the capital allocation line

The capital allocation line is a straight line and that it has the following equation:
CAL:E(rC )=rF+σC [E(rP) - rF]/ σP
In this formula P is the risky portfolio, F is riskless portfolio, and C is a
combination of portfolios P and F.
The slope of the capital allocation line is equal to the incremental return of the
portfolio to the incremental increase of risk. Hence, the slope of the capital
allocation line is called the reward-to-variability ratio because the expected return
increases continually with the increase of risk as measured by the standard
deviation.

85
Derivation of the CAL
If investors can purchase a risk free asset with some return rF, then all correctly
priced risky assets or portfolios will have expected return of the form
E(rP) = rF +bσP
where b is some incremental return to offset the risk (sometimes known as a risk
premium), and σP is the risk itself expressed as the standard deviation. By
rearranging, we can see the risk premium has the following value
b = [E(rP) - rF]/ σP
Now consider the case of another portfolio that is a combination of a risk free asset
and the correctly priced portfolio we considered above (which is itself just another
risky asset). If it is correctly priced, it will have exactly the same form:
E(rC) = rF+ σCb
Substituting in our derivation for the risk premium above:
E(rC) = rF+ σC [E(rP) - rF]/ σP
This yields the Capital Allocation Line.
The capital allocation line aids investors in choosing how much to invest in a risk-
free asset and one or more risky assets. Asset allocation is the allotment of funds
across different types of assets with varying expected risk and return levels,
whereas capital allocation is the allotment of funds between risk-free assets, such
as certain Treasury securities, and risky assets, such as equities.
Constructing Portfolios with the CAL
An easy way to adjust the risk level of a portfolio is to adjust the amount invested
in the risk-free asset. The entire set of investment opportunities includes every
single combination of risk-free and risky assets. These combinations are plotted on
a graph where the y-axis is expected return and the x-axis is the risk of the asset as
measured by standard deviation.
The simplest example is a portfolio containing two assets: a risk-free Treasury bill
and a stock. Assume that the expected return of the Treasury bill is 3% and its risk
is 0%. Further, assume that the expected return of the stock is 10% and its standard
deviation is 20%. The question that needs to be answered for any individual
investor is how much to invest in each of these assets. The expected return (ER) of
this portfolio is calculated as follows:
ER of portfolio = ER of risk-free asset x weight of risk-free asset + ER of risky
asset x (1- weight of risk-free asset)
The calculation of risk for this portfolio is simple because the standard deviation of
the Treasury bill is 0%. Thus, risk is calculated as:
Risk of portfolio = weight of risky asset x standard deviation of risky asset
In this example, if an investor were to invest 100% into the risk-free asset, the
expected return would be 3% and the risk of the portfolio would be 0%.

86
Likewise, investing 100% into the stock would give an investor an expected return
of 10% and a portfolio risk of 20%. If the investor allocated 25% to the risk-free
asset and 75% to the risky asset, the portfolio expected return and risk calculations
would be:
ER of portfolio = (3% x 25%) + (10% * 75%) = 0.75% + 7.5% = 8.25%
Risk of portfolio = 75% * 20% = 15%
Slope of the CAL
The slope of the CAL measures the trade-off between risk and return. A higher
slope means that investors receive higher expected return in exchange for taking on
more risk. The value of this calculation is known as the Sharpe ratio.
iii) The security market line (SML)/(characteristic line)
The security market line is an investment evaluation tool derived from the capital
asset pricing model . The security market line (SML) is a line drawn on a chart that
serves as a graphical representation of the capital asset pricing model (CAPM),
which shows different levels of systematic, or market risk of various marketable
securities plotted against the expected return of the entire market at a given point in
time. The market risk premium of a given security is determined by where it is
plotted on the chart in relation to the SML.
The formula for plotting the security market line is as follows:
Required Return = Risk Free Rate of Return + Beta (Market Return - Risk Free
Rate of Return)
Using the Security Market Line
The security market line is commonly used by investors in evaluating a security for
inclusion in an investment portfolio in terms of whether the security offers a
favorable expected return against its level of risk. When the security is plotted on
the SML chart, if it appears above the SML, it is considered undervalued because
the position on the chart indicates that the security offers a greater return against its
inherent risk. Conversely, if the security plots below the SML, it is considered
overvalued in price because the expected return does not overcome the inherent
risk.
Market Risk Premium/the slope of the SML
The market risk premium, or the equity risk premium, is the difference between the
expected return on a market portfolio and the risk-free rate. Market risk premium is
equal to the slope of the SML, a graphical representation of the CAPM. Market
risk premium describes the relationship between returns from an equity market
portfolio and treasury bond yields. The historical market risk premium will be the
same for all investors since the value is based on what actually happened. The
required and expected market premiums, however, will differ from investor to
investor based on risk tolerance and investing styles.

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Calculation and Application of market risk premium
The market risk premium can be calculated by subtracting the risk-free rate from
the expected equity market return, providing a quantitative measure of the extra
return demanded by market participants for increased risk. The required rate of
return for an individual asset can be calculated by multiplying the asset's beta
coefficient by the market coefficient, then adding back the risk-free rate. This is
often used as the discount rate in discounted cash flow, a popular valuation model.
The SML is determined by the market expected return of 0.5 x (20 + 5) = 12.5%,
with a beta of 1, and the T-bill return of 8% with a beta of zero. The equation for
the security market line is:
E(R) = 8% + β(12.5% - 8%).
Β E(R)
0 8.0%
1 12.5%
2 17.0%
3 21.5%
4 26.0%
5 30.5%
6 35.0%
7 39.5%

Expected return

0%
35%
30%
25%
20%
15%
10%
5%
1 2 3 4 5 6 7
Beta
Security market line

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 iv) Difference between The Capital Market Line, the
Capital Allocation Line and the Security Market Line
The CML is sometimes confused with the capital allocation line (CAL) and the
security market line (SML). While the CAL is one of an infinite number of lines
plotting the possible combinations of the risk free asset and a portfolio of risky
assets - depending on investors' return expectations — the CML is the specific
instance where the risky portfolio is the market portfolio. The CML is the CAL
with the highest Sharpe ratio (slope). The Sharpe ratio is the average return earned
in excess of the risk-free rate per unit of volatility or total risk. The greater the
value of the Sharpe ratio, the more attractive the risk-adjusted return.
The SML is derived from the CML. While the CML shows the rates of return for a
specific portfolio, the SML represents the market’s risk and return at a given time,
and shows the expected returns of individual assets. And while the measure of risk
in the CML the standard deviation of returns (total risk), the risk measure in the
SML is systematic risk, or beta. Securities that are fairly priced will plot on the
CML and the SML. Securities that plot above the CML or the SML are generating
returns that are too high for the given risk and are underpriced. Securities that plot
below CML or the SML are generating returns that are too low for the given risk
and are overpriced.

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 7. APPLICATION OF COMPUTER TECHNOLOGY IN
PORTFOLIO MANAGEMENT
7.1 Front-office transformation through technology
Asset managers are leveraging new technology to develop front-office operating
models that are cost-efficient, reliable, customizable and globally scalable.
Six drivers of front-office transformation
i) Product evolution and geographic growth
Front-office systems must support the development of complex new investments,
such as multi-asset funds and structured products, within a global operating model.
ii) Cost savings
Competition and fee transparency continue to pressure revenues, while costs
related to regulation and product development rise.
iii) Harnessing data
Technology in itself is rarely a differentiator. However, when linked with high-
quality data, technology is increasingly seen as a key driver of investment
decisions.
iv) Reporting
As investors increasingly scrutinize returns, technology is vital to consistent, cost-
effective reporting across the firm.
v) Risk management
Many front-office systems are an inefficient mixture of technologies (custom, off-
the-shelf, spreadsheets, manual processes and so on). Standardized, robust
technology can help achieve more effective governance and risk management.
vi) Shifting decision-making
Decisions on front-office technology are now as likely to be made by business
managers as by fund managers. Input from the investment division, although vital,
is now only part of the picture.
7.2 Effect of computer technology in portfolio management
(i) Lower Fee Structures
Asset management has historically been a very lucrative industry, since actively
managed funds could justify charging higher prices. There have been a number of
drivers behind the dramatic reduction in fees, with many investors hesitant to pay
even 1% these days. The rise of passive funds has put pressure on active fund fees,
technology has also helped dramatically increase transparency over the past
decade. Investors can easily compare funds by performance and fees with the click
of a mouse.
(ii) Rise of Automation
Asset management has historically been a very hands-on game for financial
advisors and other professionals. Financial advisors charge enough money to make
a living and grow a practice over time.
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New software companies are attempting to automate every aspect of an asset
management firm. Big data concepts could be leveraged to take these processes
even further down the path of automation. For example, a person’s health history
could be used to compute an actuarial table and effectively manage financial assets
automatically based on their life expectancy and that of their family or take into
account personal income when calculating tax-advantaged moves in a portfolio.
(iii) Better Value
Asset management has historically been a very challenging and time-consuming
task, which involved researching equities, bonds, and other asset classes and
building portfolios in spreadsheets over time. Technology has helped dramatically
improve the operational efficiency of many financial advisors by reducing manual
processing. After inputting a trading algorithm into a computer, asset managers can
let the computer automatically make calculations or even place trades on clients’
behalf, which frees up their time to focus on other ways to help build value for
their clients. Financial advisors and asset managers that are able to adapt to
technology more rapidly could enjoy increased market share as slower competitors
struggle to keep up the pace.
(iv) The Bottom Line
Technology could help many asset managers improve their business and increase
their profits. Those adapting quickly to technology could gain a competitive edge
over the competition and build market share, while simultaneously reducing their
operational costs.
7.3 Latest technology developments
The latest systems now provide automated trade capture with minimal manual
entry, real-time risk analysis and compliance capabilities. One example is the
capability to combine front-office portfolio reporting with back-office accounting
data in real time to produce an investment book of record (IBOR). An IBOR can
eliminate many problems associated with an accounting-based data architecture. It
also offers a central aggregation point for users to view any type of data, for any
instrument, at any time.
Front-office software also now offers good scalability. This includes the capability
to handle multi-location, multi-jurisdiction portfolios. Many managers have used
this technology in recent years as a springboard for diversified international
growth.
7.3.1 Hosted front-office systems
Hosted or managed front-office software is becoming more common. In our
experience, most firms can benefit from implementing a consistent front-office
model across markets, geographies and business units. However, larger firms
naturally offer the greatest potential for consolidation.

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Regardless of the firm, the hosted approach has several potential benefits:
i) Simplicity
Hosted systems reduce the need for internal administration. Changes related to
market and regulatory requirements (MiFID, Dodd-Frank and so on) can be
incorporated more quickly.
ii) Focus
Hosted systems let technology specialists focus on higher-value activities that
provide a competitive advantage.
iii) Cost
Most hosted systems require lower upfront investment and licensing costs. They
also offer potentially significant reductions in technology staffing. Finally, vendors
have worked hard to reassure their customers about the security of proprietary data,
intellectual property and identifiable investor information.
iv) The broad reach of front-office transformation
Front-office transformation can have a major impact on asset management’s entire
value chain. Because activities in the investment division touch on most aspects of
an asset manager’s operations, changes to technology and operating models are felt
widely.
Strengthening capabilities in the investment division makes it easier to deploy
enterprise-wide improvements in areas such as risk management, client reporting,
product development, compliance and settlement.
v) Creating a successful front-office transformation
Although transformation might begin with technology, upgraded systems must be
matched by changes in process, products, third parties, governance and
organization. The resulting upheavals need careful management, under the same
sort of monitoring and central oversight as any other business change.
A second key to success is considering the process of transformation from an
enterprise-wide perspective. Scope for complementary improvements in middle
and back offices must be factored in from the start.
The third key is to avoid viewing new front-office technology as a one-off event.
Tight, well-drafted service level agreements are vital.
7.4 IT portfolio management
IT portfolio management is the application of systematic management to the
investments, projects and activities of enterprise Information Technology (IT)
departments. Examples of IT portfolios would be planned initiatives, projects, and
ongoing IT services (such as application support). IT portfolio management is
distinct from IT financial management in that it has an explicitly directive,
strategic goal in determining what to continue investing in versus what to divest
from. At its most mature, IT portfolio management is accomplished through the
creation of three portfolios:
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 i) Application Portfolio
Management of this portfolio focuses on comparing spending on established
systems based upon their relative value to the organization. The comparison can be
based upon the level of contribution in terms of IT investment’s profitability.
Additionally, this comparison can also be based upon the non-tangible factors such
as organizations’ level of experience with a certain technology, users’ familiarity
with the applications and infrastructure, and external forces such as emergence of
new technologies and obsolescence of old ones.
ii) Infrastructure Portfolio
Infrastructure management is sometimes divided into categories of systems
management, network management, and storage management. The ability of
organizations to exploit IT infrastructure, operations and management
sourcing/service solutions not only depends on the availability, cost and
effectiveness of applications and services, but also with coming to terms with
solution providers, and managing the entire sourcing process. In the rush to reduce
costs, increase IT quality and increase competitiveness by way of selective IT
sourcing and services, many organizations do not consider the management side of
the equation. The predictable result of this neglect is overpayment, cost overruns,
unmet expectations and outright failure.
iii) Project Portfolio
This type of portfolio management specially addresses the issues with spending on
the development of innovative capabilities in terms of potential ROI, reducing
investment overlaps in situations where reorganization or acquisition occurs, or
complying with legal or regulatory mandates. The management issues with project-
oriented portfolio management can be judged by criteria such as ROI, strategic
alignment, data cleanliness, maintenance savings, suitability of resulting solution
and the relative value of new investments to replace these projects.
Information Technology portfolio management as a systematic discipline is more
applicable to larger IT organizations; in smaller organizations its concerns might
be generalized into IT planning and governance as a whole.
7.4.1 Benefits of using IT portfolio management
There are several benefits of applying IT portfolio management approach for IT
investments. Agility of portfolio management is its biggest advantage over
investment approaches and methods. Other benefits include central oversight of
budget, risk management, strategic alignment of IT investments, demand and
investment management along with standardization of investment procedure, rules
and plans.

93
 7.4.2 Implementing IT portfolio management
There are a number of hurdles and success factors in implement IT portfolio
management approach. To overcome these hurdles, simple methods can be used.
These include
- Plan
- Build
- Maintain
- Retire
Other implementation methods include
(1) Risk profile analysis
Figure out what needs to be measured and what risks are associated with it.
(2) Decide on the Diversification of projects
Infrastructure and technologies is an important tool that IT portfolio management
provides to judge the level of investments on the basis of how investments should
be made in various elements of the portfolio.
(3) Continuous Alignment with business goals
Organizations should have a buy-in in the portfolio and
(4) Continuous Improvement
Use lessons learned and make investment adjustments.
1. Developing and evolving IT portfolio governance and organization
2. Assessing IT portfolio management process execution
There is no single best way to implement IT portfolio approach and therefore
variety of approaches can be applied.

94
Future value interest factor of $1 per period at i% for n periods, FVIF(i,n).
Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 1.010 1.020 1.030 1.040 1.050 1.060 1.070 1.080 1.090 1.100
2 1.020 1.040 1.061 1.082 1.103 1.124 1.145 1.166 1.188 1.210
3 1.030 1.061 1.093 1.125 1.158 1.191 1.225 1.260 1.295 1.331
4 1.041 1.082 1.126 1.170 1.216 1.262 1.311 1.360 1.412 1.464
5 1.051 1.104 1.159 1.217 1.276 1.338 1.403 1.469 1.539 1.611
6 1.062 1.126 1.194 1.265 1.340 1.419 1.501 1.587 1.677 1.772
7 1.072 1.149 1.230 1.316 1.407 1.504 1.606 1.714 1.828 1.949
8 1.083 1.172 1.267 1.369 1.477 1.594 1.718 1.851 1.993 2.144
9 1.094 1.195 1.305 1.423 1.551 1.689 1.838 1.999 2.172 2.358
10 1.105 1.219 1.344 1.480 1.629 1.791 1.967 2.159 2.367 2.594
11 1.116 1.243 1.384 1.539 1.710 1.898 2.105 2.332 2.580 2.853
12 1.127 1.268 1.426 1.601 1.796 2.012 2.252 2.518 2.813 3.138
13 1.138 1.294 1.469 1.665 1.886 2.133 2.410 2.720 3.066 3.452
14 1.149 1.319 1.513 1.732 1.980 2.261 2.579 2.937 3.342 3.797
15 1.161 1.346 1.558 1.801 2.079 2.397 2.759 3.172 3.642 4.177
16 1.173 1.373 1.605 1.873 2.183 2.540 2.952 3.426 3.970 4.595
17 1.184 1.400 1.653 1.948 2.292 2.693 3.159 3.700 4.328 5.054
18 1.196 1.428 1.702 2.026 2.407 2.854 3.380 3.996 4.717 5.560
19 1.208 1.457 1.754 2.107 2.527 3.026 3.617 4.316 5.142 6.116
20 1.220 1.486 1.806 2.191 2.653 3.207 3.870 4.661 5.604 6.727
25 1.282 1.641 2.094 2.666 3.386 4.292 5.427 6.848 8.623 10.835
30 1.348 1.811 2.427 3.243 4.322 5.743 7.612 10.063 13.268 17.449
35 1.417 2.000 2.814 3.946 5.516 7.686 10.677 14.785 20.414 28.102
40 1.489 2.208 3.262 4.801 7.040 10.286 14.974 21.725 31.409 45.259
50 1.645 2.692 4.384 7.107 11.467 18.420 29.457 46.902 74.358 117.391

95
Future value interest factor of $1 per period at i% for n periods, FVIF(i,n).
Period 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 1.010 1.020 1.030 1.040 1.050 1.060 1.070 1.080 1.090 1.100
2 1.020 1.040 1.061 1.082 1.103 1.124 1.145 1.166 1.188 1.210
3 1.030 1.061 1.093 1.125 1.158 1.191 1.225 1.260 1.295 1.331
4 1.041 1.082 1.126 1.170 1.216 1.262 1.311 1.360 1.412 1.464
5 1.051 1.104 1.159 1.217 1.276 1.338 1.403 1.469 1.539 1.611
6 1.062 1.126 1.194 1.265 1.340 1.419 1.501 1.587 1.677 1.772
7 1.072 1.149 1.230 1.316 1.407 1.504 1.606 1.714 1.828 1.949
8 1.083 1.172 1.267 1.369 1.477 1.594 1.718 1.851 1.993 2.144
9 1.094 1.195 1.305 1.423 1.551 1.689 1.838 1.999 2.172 2.358
10 1.105 1.219 1.344 1.480 1.629 1.791 1.967 2.159 2.367 2.594
11 1.116 1.243 1.384 1.539 1.710 1.898 2.105 2.332 2.580 2.853
12 1.127 1.268 1.426 1.601 1.796 2.012 2.252 2.518 2.813 3.138
13 1.138 1.294 1.469 1.665 1.886 2.133 2.410 2.720 3.066 3.452
14 1.149 1.319 1.513 1.732 1.980 2.261 2.579 2.937 3.342 3.797
15 1.161 1.346 1.558 1.801 2.079 2.397 2.759 3.172 3.642 4.177
16 1.173 1.373 1.605 1.873 2.183 2.540 2.952 3.426 3.970 4.595
17 1.184 1.400 1.653 1.948 2.292 2.693 3.159 3.700 4.328 5.054
18 1.196 1.428 1.702 2.026 2.407 2.854 3.380 3.996 4.717 5.560
19 1.208 1.457 1.754 2.107 2.527 3.026 3.617 4.316 5.142 6.116
20 1.220 1.486 1.806 2.191 2.653 3.207 3.870 4.661 5.604 6.727
25 1.282 1.641 2.094 2.666 3.386 4.292 5.427 6.848 8.623 10.835
30 1.348 1.811 2.427 3.243 4.322 5.743 7.612 10.063 13.268 17.449
35 1.417 2.000 2.814 3.946 5.516 7.686 10.677 14.785 20.414 28.102
40 1.489 2.208 3.262 4.801 7.040 10.286 14.974 21.725 31.409 45.259
50 1.645 2.692 4.384 7.107 11.467 18.420 29.457 46.902 74.358 117.391

96
Present value interest factor of $1 per period at i% for n periods, PVIF(i,n).
Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621
6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239
16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218
17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198
18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180
19 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 0.164
20 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149
25 0.780 0.610 0.478 0.375 0.295 0.233 0.184 0.146 0.116 0.092
30 0.742 0.552 0.412 0.308 0.231 0.174 0.131 0.099 0.075 0.057
35 0.706 0.500 0.355 0.253 0.181 0.130 0.094 0.068 0.049 0.036
40 0.672 0.453 0.307 0.208 0.142 0.097 0.067 0.046 0.032 0.022
50 0.608 0.372 0.228 0.141 0.087 0.054 0.034 0.021 0.013 0.009

97
Present value interest factor of $1 per period at i% for n periods, PVIF(i,n).
Period 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621
6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239
16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218
17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198
18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180
19 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 0.164
20 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149
25 0.780 0.610 0.478 0.375 0.295 0.233 0.184 0.146 0.116 0.092
30 0.742 0.552 0.412 0.308 0.231 0.174 0.131 0.099 0.075 0.057
35 0.706 0.500 0.355 0.253 0.181 0.130 0.094 0.068 0.049 0.036
40 0.672 0.453 0.307 0.208 0.142 0.097 0.067 0.046 0.032 0.022
50 0.608 0.372 0.228 0.141 0.087 0.054 0.034 0.021 0.013 0.009

98
Future value interest factor of an ordinary annuity of $1 per period at i% for n periods, FVIFA(i,n).
Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000
2 2.010 2.020 2.030 2.040 2.050 2.060 2.070 2.080 2.090 2.100
3 3.030 3.060 3.091 3.122 3.153 3.184 3.215 3.246 3.278 3.310
4 4.060 4.122 4.184 4.246 4.310 4.375 4.440 4.506 4.573 4.641
5 5.101 5.204 5.309 5.416 5.526 5.637 5.751 5.867 5.985 6.105
6 6.152 6.308 6.468 6.633 6.802 6.975 7.153 7.336 7.523 7.716
7 7.214 7.434 7.662 7.898 8.142 8.394 8.654 8.923 9.200 9.487
8 8.286 8.583 8.892 9.214 9.549 9.897 10.260 10.637 11.028 11.436
9 9.369 9.755 10.159 10.583 11.027 11.491 11.978 12.488 13.021 13.579
10 10.462 10.950 11.464 12.006 12.578 13.181 13.816 14.487 15.193 15.937
11 11.567 12.169 12.808 13.486 14.207 14.972 15.784 16.645 17.560 18.531
12 12.683 13.412 14.192 15.026 15.917 16.870 17.888 18.977 20.141 21.384
13 13.809 14.680 15.618 16.627 17.713 18.882 20.141 21.495 22.953 24.523
14 14.947 15.974 17.086 18.292 19.599 21.015 22.550 24.215 26.019 27.975
15 16.097 17.293 18.599 20.024 21.579 23.276 25.129 27.152 29.361 31.772
16 17.258 18.639 20.157 21.825 23.657 25.673 27.888 30.324 33.003 35.950
17 18.430 20.012 21.762 23.698 25.840 28.213 30.840 33.750 36.974 40.545
18 19.615 21.412 23.414 25.645 28.132 30.906 33.999 37.450 41.301 45.599
19 20.811 22.841 25.117 27.671 30.539 33.760 37.379 41.446 46.018 51.159
20 22.019 24.297 26.870 29.778 33.066 36.786 40.995 45.762 51.160 57.275
25 28.243 32.030 36.459 41.646 47.727 54.865 63.249 73.106 84.701 98.347
30 34.785 40.568 47.575 56.085 66.439 79.058 94.461 113.28 136.31 164.49
35 41.660 49.994 60.462 73.652 90.320 111.43 138.24 172.32 215.71 271.02
40 48.886 60.402 75.401 95.026 120.80 154.76 199.64 259.06 337.88 442.59
50 64.463 84.579 112.80 152.67 209.35 290.34 406.53 573.77 815.08 1,163.9

99
Future value interest factor of an ordinary annuity of $1 per period at i% for n periods, FVIFA(i,n).
Period 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000
2 2.010 2.020 2.030 2.040 2.050 2.060 2.070 2.080 2.090 2.100
3 3.030 3.060 3.091 3.122 3.153 3.184 3.215 3.246 3.278 3.310
4 4.060 4.122 4.184 4.246 4.310 4.375 4.440 4.506 4.573 4.641
5 5.101 5.204 5.309 5.416 5.526 5.637 5.751 5.867 5.985 6.105
6 6.152 6.308 6.468 6.633 6.802 6.975 7.153 7.336 7.523 7.716
7 7.214 7.434 7.662 7.898 8.142 8.394 8.654 8.923 9.200 9.487
8 8.286 8.583 8.892 9.214 9.549 9.897 10.260 10.637 11.028 11.436
9 9.369 9.755 10.159 10.583 11.027 11.491 11.978 12.488 13.021 13.579
10 10.462 10.950 11.464 12.006 12.578 13.181 13.816 14.487 15.193 15.937
11 11.567 12.169 12.808 13.486 14.207 14.972 15.784 16.645 17.560 18.531
12 12.683 13.412 14.192 15.026 15.917 16.870 17.888 18.977 20.141 21.384
13 13.809 14.680 15.618 16.627 17.713 18.882 20.141 21.495 22.953 24.523
14 14.947 15.974 17.086 18.292 19.599 21.015 22.550 24.215 26.019 27.975
15 16.097 17.293 18.599 20.024 21.579 23.276 25.129 27.152 29.361 31.772
16 17.258 18.639 20.157 21.825 23.657 25.673 27.888 30.324 33.003 35.950
17 18.430 20.012 21.762 23.698 25.840 28.213 30.840 33.750 36.974 40.54
18 19.615 21.412 23.414 25.645 28.132 30.906 33.999 37.45 41.30 45.60
19 20.811 22.841 25.117 27.671 30.539 33.760 37.38 41.45 46.02 51.16
20 22.019 24.297 26.870 29.778 33.07 36.79 41.00 45.76 51.16 57.27
25 28.24 32.03 36.46 41.65 47.73 54.86 63.25 73.11 84.70 98.35
30 34.78 40.57 47.58 56.08 66.44 79.06 94.46 113.28 136.31 164.5
35 41.66 49.99 60.46 73.65 90.32 111.4 138.2 172.3 215.7 271.0
40 48.89 60.40 75.4 95.0 120.8 154.8 199.6 259.1 337.9 442.6
50 64.5 84.6 112.8 152.7 209.3 290 407 574 815 1,164

100
Present value interest factor of an (ordinary) annuity of $1 per period at i% for n periods, PVIFA(i,n).
Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145
11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495
12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814
13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103
14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367
15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606
16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824
17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022
18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201
19 17.226 15.678 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365
20 18.046 16.351 14.877 13.590 12.462 11.470 10.594 9.818 9.129 8.514
25 22.023 19.523 17.413 15.622 14.094 12.783 11.654 10.675 9.823 9.077
30 25.808 22.396 19.600 17.292 15.372 13.765 12.409 11.258 10.274 9.427
35 29.409 24.999 21.487 18.665 16.374 14.498 12.948 11.655 10.567 9.644
40 32.835 27.355 23.115 19.793 17.159 15.046 13.332 11.925 10.757 9.779
50 39.196 31.424 25.730 21.482 18.256 15.762 13.801 12.233 10.962 9.915

101
Present value interest factor of an (ordinary) annuity of $1 per period at i% for n periods, PVIFA(i,n).
Period 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145
11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495
12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814
13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103
14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367
15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606
16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824
17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022
18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201
19 17.226 15.678 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365
20 18.046 16.351 14.877 13.590 12.462 11.470 10.594 9.818 9.129 8.514
25 22.023 19.523 17.413 15.622 14.094 12.783 11.654 10.675 9.823 9.077
30 25.808 22.396 19.600 17.292 15.372 13.765 12.409 11.258 10.274 9.427
35 29.409 24.999 21.487 18.665 16.374 14.498 12.948 11.655 10.567 9.644
40 32.835 27.355 23.115 19.793 17.159 15.046 13.332 11.925 10.757 9.779
50 39.196 31.424 25.730 21.482 18.256 15.762 13.801 12.233 10.962 9.915

102