Portfolio & Capital Markets

Overview
Meaning :-
Portfolio And Capital Markets 1. Investment
2. Portfolio
3. Capital Market
Jeet R.Shah Investment Attributes
CM
M.Com , CFP Approaches to Investment Decision
Making
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Investment Two Key Aspects

Rarely ,Income = Expenses. 1. Time .
Income > Expenses = Savings 2. Risk.
Income < Expenses = Borrowings Sacrifice takes place now and is certain .
The tradeoff of present consumption for a higher The benefit is expected in the future and is
level of future consumption is the reason for uncertain.
saving.What you do with the savings to make them In some investment Time element is dominant –
increase over a time is Investment. Govt Bonds.
Thus it is the purchase of any asset with the In some investment Risk element is dominant –
potential to yield future financial benefit to the Stock Options.
purchaser. In some investment both Time and Risk are
dominant –Equity Shares.
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1
Two concepts Portfolio
1. Economic Investment : A portable case for holding paper,
Addition to the Capital Stock of the society. Drawings,etc
Capital Stock of the society are the goods which
are used in the production of other goods. All the investments of an individual
2. Financial Investment :
This is an allocation of monetary resources to
the assets that are expected to yield some gain or
return over a period of time.
It means an exchange of financial claims such as
shares.

Financial Market Classification

A Financial Market is a market for the Nature Of claim – a. Debt Market
creation and exchange of financial assets. b. Equity Market
Functions :-
Maturity Of Claim – a. Money Market
1. Facilitates Price Discovery b.Capital Market
2. Provides Liquidity
3. Reduces cost of transacting. Seasoning Of Claim – a. Primary Market
b. Secondary Market

2
Classification contd…. Investment Attributes
Timing of Delivery – a. Cash / Spot Market 1. Rate Of Return
b. Forward or Futures 2. Risk
3. Marketability
Organisational Structure – a. Exchange Traded
b. Over the Counter
4. Tax Shelter
5. Convenience

Evaluation Of Various Investment Avenues Evaluation Of Various Investment Avenues

Return Risk Marketa Tax Conveni Return Risk Marketa Tax Conveni
bility / Shelter ence bility / Shelter ence
Liquidity Liquidity
Current Capital Current Capital
Yield Appreciati Yield Appreciati
on on
Equity Low High High Fairly High High Bank Moderate Nil Negligible High Nil Very High
Shares High Deposits
Non- High Negligible Low Average Nil High PPF Nil Moderate Nil Average Sec 80C Very High
convertible benefit
Debentures LIP Nil Moderate Nil Average Sec 80C Very High
benefit
Equity Low High High High High Very High Real Moderate Moderate Negligible Low High Fair
Schemes Estate
Debt Moderate Low Low High No tax on Very High Gold & Nil Moderate Average Average Nil Average
Schemes Dividends Silver

3
Approaches to Fundamental Approach
Investment Decision Making
Fundamental Approach It is a method of forecasting the future price
movements of a financial instrument based
Psychological / Technical Approach
on economic ,social , political and other
Academic Approach relevant factors and the statistics that will
Eclectic Approach affect the basic supply and demand of
whatever underlines the financial instrument.
Cybernetic Analysis
It is an answer to the question of what to buy
and why to buy.

Technical Approach Academic Approach

In his book “Technical Analysis Explained” , Martin Ping

explains :
Tenets
“The TA approach to investing 1. Market Price approx equals to Intrinsic
- is essentially a reflection of the idea that prices move in Value
trends
-which are determined by the changing attitudes of 2. Stock price behaviour corresponds to a
investors towards a variety of economic,monetary, random walk
political & psychological forces.
- The art of TA – for it is an art – is to identify trend 3. There is a positive relationship between risk
changes at an early stage & and return
-to maintain an investment posture until the weight of the
evidence indicates that the trend has been reversed.”
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Eclectic Approach Cybernetic Analysis
Neither FA nor TA should be used in isolation. Jerry Felson offers an alternative to the efficient
It is better to use The Eclectic Approach. market theory in his book, Cybernetic Approach
to Stock Market Analysis (Exposition Press, 1975)
This means- in order to bypass its perceived limitations and
Conduct FA to establish certain value “anchors.” deficiencies.
Do TA to assess the state of the market psychology . According to Felson, the extreme complexity of
Combine FA and TA to determine which securities the stock market and the environment in which it
are worth- buying, holding and disposing off. operates as well as inadequate investment tools
Respect Market Price and do not show excessive zeal
hamper the investor from earning above-average
in “beating the market” investment returns.
Accept that for higher return there are higher risk.

Cybernetic Analysis Cybernetic Analysis

Using cybernetics concepts (the science and In plain language, the cybernetics
control of communication, and mathematical
analysis of the flow of information) and
approach automates the investment
artificial intelligence (advanced cybernetics) decision-making process through the
techniques, Felson proposes developing use of pattern recognition, learning
judgmental decision-making processes by system theory, and other methods,
weighing evidence and formalizing
investment analysis. removing the imperfect human factor
and theoretically improving investment
returns.
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Cybernetic Analysis
Felson stresses that no investment analysis
can be very successful unless it conforms to Risk And Return
the law of requisite variety.
In other words, the investment decision
system must be as complex and as variable
as the system (stock market) which it is
trying to interpret.
According to Felson, this is where other
investment systems fail.
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Risk Types of Risk

Risk is the condition in which there is a possibility of Total Risk =
an adverse deviation from a desired outcome that is
expected or hoped for. Unique / unsystematic / Diversifiable risk
-Vaughan and Vaughan
Risk in holding securities is generally associated with
+
possibility that realized returns will be less than the Market / systematic / Non- Diversifiable
returns that were expected.
Thus in investment analysis it is variability of return. risk
The source of such disappointment is the failure of
dividends (interest) and/or the security’s price to
materialize as expected.
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Market / systematic / Non- Diversifiable risk Market / systematic / Non- Diversifiable risk
contd….
Some influences are external to the firm, cannot be Their effect is to cause prices of nearly all individual
controlled, and affect large numbers of securities. common stocks and/or all individual bonds to move
In investments, those forces that are uncontrollable, together in the same manner.
external and broad in their effect are called sources It is measured by Beta.
of systematic risk.
Systematic risk refers to that portion of total
variability in return caused by factors affecting the
prices of all securities.
Economic, political, and sociological changes are
sources of systematic risk.

Unique / unsystematic / Diversifiable risk

Unique / unsystematic / Diversifiable risk contd….
Some influences are internal to the firm and are Factors such as management capability, consumer
controllable to a large degree. preferences, and labor strikes cause systematic
Controllable internal factors somewhat peculiar to variability of returns in a firm..
industries and/or firms are refereed to as sources of Unsystematic factors are largely independent of
unsystematic risk. factors affecting securities markets in general.
Unsystematic risk is the portion of total risk that is Because these factors affect one firm, they must be
unique to a firm or industry. examined for each firm

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Total risk Sources of Systematic Risk
1.Market Risk
Finding stock prices falling from time to time while a
company’s earnings are rising, and vice versa, is not
uncommon.
The price of a stock may fluctuate widely within a
short span of time even though earnings remain
unchanged.
The causes of this phenomenon are varied, but it is
mainly due to a change in investors’ attitudes toward
equities in general, or toward certain types or groups
of securities in particular.
Sources of Systematic Risk Sources of Systematic Risk
Market Risk contd … 2.Interest-Rate Risk

Variability in return on most common stocks that is Interest-rate risk refers to the uncertainty of future
due to basic sweeping changes in investors market values and of the size of future income,
expectations is referred to as market risk. caused by fluctuations in the general level of interest
Market risk is caused by investor reaction to tangible rates.
as well as intangible events.

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Sources of Systematic Risk Sources of Unsystematic Risk
3.Purchasing-Power Risk The uncertainty surroundings the ability of the issuer
Market risk and interest-rate risk can be defined in to make payments on securities stems from two
terms of uncertainties as to the amount of current sources:
dollars to be received by an investor. (1) the operating environment of the business, and
Purchasing-power risk is the uncertainty of the (2) the financing of the firm.
purchasing power of the amounts to be received. These risks are referred to as business risk and
In more everyday terms, purchasing-power risk financial risk, respectively.

refers to the impact of inflation or deflation on an They are strictly a function of the operating
investment. conditions of the firm and the way in which it

chooses to finance its operations.
Sources of Unsystematic Risk Sources of Unsystematic Risk

1.Business Risk Each firm has its own set of internal risks, and the
Business risk is a function of the operating conditions degree to which it is successful in coping with them is
faced by a firm and the variability these conditions reflected in operating efficiency.
inject into operating income To large extent, external business risk is the result of
Business risk can be divided into two broad operating conditions imposes upon the firm by
categories: external and internal. circumstances beyond its control.
Internal business risk is largely associated with the Each firm also faces its own set of external
efficiency with which a firm conducts its operations risks,depending upon the specific operating
with in the broader operating environment imposed environmental factors with which it must deal.
upon it.

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Sources of Unsystematic Risk Examples of risk
2.Financial Risk Systematic Risk Unsystematic Risk
Financial risk is associated with the way in which a 1. Interest rate Risk 1. Competition
company finances its activities. 2. Forex risk 2. Specific Law
We usually gauge financial risk by looking at the 3. Political Risk 3. Capital Structure
capital structure of a firm. 4. Purchasing Power Risk 4. Product
The presence of borrowed money of debt in the 5. Sentiments 5. Raw-materials
capital structure creates fixed payment in the form of 6. Other macro-economic 6. Manpower
interest that must be sustained by the firm. risk 7. Other internal firm
specific factors

Return Measures of Return

It is the primary motive behind investments. 1. Total Return (HPR) , R = C + P e
It represents the reward for undertaking the ----------------
investment.
Pb
Generally the investors who sacrifice their current
income would like to be compensated for : C= cash payment received during the year.
1. The time or period of sacrifice. P e = ending price
2. The expected rate of inflation. P b = Beginning price
3. The risk associated with the investment.
2. HPY = HPR - 1
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Measures of Return contd…. Real Rate Of Return
Annual HPR = HPR 1/n Return adjusted for inflation = 1+ Nominal Return
----------------------- - 1
Annual HPY ( CAGR )= Annual HPR -1 1+Inflation Rate

Mean Historical Returns Example of AM & GM

Single Investment BEGINNING ENDING
1. Arithmetic Mean = ∑ HPY / n YEAR VALUE VALUE HPR HPY
1 100.0 115.0 1.15 0.15
2. Geometric Mean =
2 115.0 138.0 1.20 0.20
3 138.0 110.4 0.80 –0.20

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Example of AM & GM contd… GM V/S AM
AM = [(0.15) + (0.20) + (–0.20)]/3 Investors are typically concerned with long-term
performance when comparing alternative
= 0.15/3 investments.
= 0.05 = 5% GM is considered a superior measure of the long-
term mean rate of return because it indicates the
compound annual rate of return based on the ending
GM = [(1.15) ⋅ (1.20) ⋅ (0.80)]^1/3 – 1 value of the investment versus its beginning value.
Specifically, using the prior example, if we
= (1.104)^1/3 – 1 compounded 3.353 percent for three years,
= 1.03353 – 1 (1.03353)3, we would get an ending wealth value of
1.104.
= 0.03353 = 3.353%
GM V/S AM contd…. GM V/S AM contd….

Although the arithmetic average provides a good The annual HPYs would be:
indication of the expected rate of return for an
investment during a future individual year, it is BEGINNING ENDING
biased upward if you are attempting to measure an YEAR VALUE VALUE HPR HPY
asset’s long-term performance. 1 50 100 2.00 1.00
This is obvious for a volatile security. 2 100 50 0.50 –0.50
Consider, for example, a security that increases in
price from Rs.50 to Rs. 100 during year 1 and drops
back to Rs. 50 during year 2.

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GM V/S AM contd…. A Portfolio of Investments
This would give an AM rate of return of: The mean historical rate of return (HPY) for a
[(1.00) + (–0.50)]/2 = .50/2 portfolio of investments is measured as the weighted
= 0.25 = 25% average of the HPY s for the individual investments in
This investment brought no change in wealth and the portfolio, or the overall change in value of the
therefore no return, yet the AM rate of return is original portfolio.
computed to be 25 percent. The weights used in computing the averages are the
The GM rate of return would be: relative beginning market values for each
(2.00 × 0.50)^1/2 – 1 = (1.00)^1/2 – 1 investment; this is referred to as dollar-weighted or
= 1.00 – 1 = 0% value-weighted mean rate of return.
This answer of a 0 percent rate of return accurately
measures the fact that there was no change in
wealth from this investment over the two-year
Services
period. Jeet R .Shah 49 Services Jeet R .Shah 50
COMPUTATION OF HOLDING PERIOD YIELD FOR A COMPUTATION OF HOLDING PERIOD YIELD FOR A
PORTFOLIO PORTFOLIO Contd….
Invt No. of P Beg P End HPR HPY Mkt . Wted
b e HPR = 2,19,00,000
Share Mkt. Mkt. Wt HPY
Value Value ---------------
A 1,00,000 10 10,00,000 12 12,00,000 1.2 20% 0.05 0.01 2,00,00,000
= 1.095
2,00,000 20 40,00,000 21 42,00,000 1.05 5% 0.20 0.01
B HPY = HPR – 1
=1.095 –1 = 0.095 = 9.5 %
5,00,000 30 1,50,00,000 33 1,65,00,000 1.10 10% 0.75 0.075
C
Total 2,00,00,000 2,19,00,000 0.095

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Calculating Expected Rates Of Return Calculating Expected Rates Of Return contd….
In the examples in the prior section, we examined An investor determines how certain the expected rate
realized historical rates of return. of return on an investment is by analyzing estimates
of expected returns.
In contrast, an investor who is evaluating a future
investment alternative expects or anticipates a To do this, the investor assigns probability values to
all possible returns.
certain rate of return.
These probability values range from zero, which
The investor might say that he or she expects the means no chance of the return, to one, which
investment will provide a rate of return of 10 percent, indicates complete certainty that the investment will
but this is actually the investor’s most likely estimate, provide the specified rate of return.
also referred to as a point estimate. These probabilities are typically subjective estimates
based on the historical performance

The expected return from an investment

defined
Perfect Certainty
Probability Distribution for risk – free Investment
Expected Return
= Sum of (Probability of Return) * (Possible Return)
∑ Pi * Ri
i =1

14
Uncertainty
PROBABILITY DISTRIBUTION FOR RISKY INVESTMENT WITH
THREE POSSIBLE RATES OF RETURN

Choice Calculation
The expected rate of return for this investment is RATE OF
the same as the certain return discussed in the first ECONOMIC CONDITIONS PROBABILITY RETURN
example; but, in this case, the investor is highly Strong economy, no inflation 0.15 0.20
uncertain about the actual rate of return.
Weak economy, above-average inflation 0.15 –0.20
This would be considered a risky investment because
No major change in economy 0.70 0.10
of that uncertainty.
We would anticipate that an investor faced with the
choice between this risky investment and the certain The computation of the expected rate of return [E(Ri)] is as
(risk-free) case would select the certain alternative. follows:
This expectation is based on the belief that most E(Ri) = [(0.15)(0.20)] + [(0.15)(–0.20)] + [(0.70)(0.10)]
investors are risk averse, which means that if = 0.07
everything else is the same, they will select the
investment that offers greater certainty.
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Measuring the Risk of Expected Rate
Of Return Measures Of Risk
Two possible measures of risk (uncertainty) have Variance is the mean of deviation from
received support in theoretical work on portfolio Arithmetic Mean
theory:
1. the variance and
2. the standard deviation of the estimated distribution
of expected returns.

Measures Of Risk Expected Risk on a Portfolio

Standard Deviation is the square root of Expected Risk on a Portfolio =
variance
σ 2p = xA2σ A2 + xB2σ B2 + 2 xA xB ρ ABσ Aσ B
x A = Proportion Of security A in the
portfolio
x B = Proportion Of security B in the
portfolio
pAB = Corelation between returns of
security A & B
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Example Example contd..
What is the expected return and variance of this
Stock A Stock B two-security portfolio?
Solution: The expected return of this two-security
Expected return .015 .020 portfolio is:
Variance .050 .060 n

E ( R% p ) = ∑
i =1
 x i E ( R% i ) 
Standard deviation .224 .245
=  x A E ( R% A )  +  x B E ( R% B ) 
Weight 40% 60% = [ 0 .4 ( 0 .0 1 5 ) ] + [ 0 .6 ( 0 .0 2 0 ) ]
Correlation coefficient .50 = 0 .0 1 8 = 1 .8 0 %

Example contd….. A Relative Measure of Risk

Solution (cont’d): The variance of this two-security
portfolio is: In some cases, an unadjusted variance or standard deviation
can be misleading. If conditions for two or more investment
alternatives are not similar
—that is, if there are major differences in the expected rates of
return—it is necessary to use a measure of relative variability to
σ 2p = xA2σA2 + xB2σB2 + 2xAxBρABσAσB indicate risk per unit of expected return. A widely used relative
measure of risk is the coefficient of variation (CV).
= (.4)2 (.05) + (.6)2 (.06) + 2(.4)(.6)(.5)(.224)(.245) Coefficient of Variation (CV) = Standard Deviation of Returns
------------------------------------
= .0080 +.0216 +.0132 Expected Rate of Return
= .0428
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A Relative Measure of Risk contd… A Relative Measure of Risk contd…
This measure of relative variability and risk is used by CV A = 0 05
financial analysts to compare alternative investments
with widely different rates of return and standard ------- = 0 714
deviations of returns.
0 07
As an illustration, consider the following two
investments:
INVESTMENT A INVESTMENT B
CV B = 0 07
Expected return 0.07 0.12
Standard deviation 0.05 0.07 −−−− = 0 583
0 12
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often wipe a bloody nose.
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Overview

Investment Two Key Aspects

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Financial Market Classification

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Evaluation Of Various Investment Avenues Evaluation Of Various Investment Avenues

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Technical Approach Academic Approach

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Cybernetic Analysis Cybernetic Analysis

Risk Types of Risk

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Unique / unsystematic / Diversifiable risk

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Sources of Systematic Risk Sources of Systematic Risk

Market Risk contd … 2.Interest-Rate Risk

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In more everyday terms, purchasing-power risk financial risk, respectively.

investment. conditions of the firm and the way in which it

Sources of Unsystematic Risk Sources of Unsystematic Risk

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Return Measures of Return

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Mean Historical Returns Example of AM & GM

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GM V/S AM contd…. GM V/S AM contd….

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Total 2,00,00,000 2,19,00,000 0.095

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The expected return from an investment

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Measures Of Risk Expected Risk on a Portfolio

Variance .050 .060 n

Correlation coefficient .50 = 0 .0 1 8 = 1 .8 0 %

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Example contd….. A Relative Measure of Risk

Those who in Quarrel interpose must

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