Portfolio Management – Chpt.

II
Dr S.M.Tariq Zafar
M.Com, PGDMM, PhD (Social Sector Investment)
syed.zafar@omancollege.edu.om,
smtariqz2015@gmail.com
 Introduction

• Modern Portfolio Theory and Construction

• Approaches of Portfolio Construction
• Markowitz Mean Variance Model
• Markowitz Efficient Frontiers Model
• Capital Asset Pricing Model (CAPM)
• Fisher Black Noise Theory:
• Random Walk Hypothesis (RWH)
• Efficient Market Hypothesis
• Form of Market
• Arbitrage Pricing Model
• Fair Game Concept
 Modern Portfolio Theory and Construction:

Portfolio:
• Portfolio is a combination of securities as stocks bonds and money market
instruments.
• Portfolio management is concerned with efficient management of instrument in the
securities
• Process of blending together the broad asset classes so as to obtain optimum return
with minimum risk is called portfolio construction.
• An investment is defined as the current commitment of funds for a period in order
to derive a future flow of funds that will compensate the investing unit
• Diversification of investment helps to spread risk over many assets.
• A diversification of securities gives the assurance of obtaining the anticipated
return on the portfolio.
• In diversified portfolio some securities may not perform some may perform, thus
balance exist.
• Keeping a portfolio of single security is risky game. It is common practice to
diversify securities in the portfolio.
 Approaches of Portfolio Construction:
Communally there are two approaches in the construction of portfolio of securities.
Traditional Approach and Modern Approach.
(1) Traditional Approach: In traditional approach, investor’s needs in terms of income
and capital appreciation are evaluated and appropriate securities are selected to meet
the needs of the investors. The common practice in traditional approach is to evaluate
the entire financial plan of the individual. Basically Traditional Approach deals with
two major decisions.
(a) Determining the objective of the portfolio
(a) Selection of securities to be included in the portfolio
Normally this is carried in four to six step:

• Before formulating the objectives the constraints of the investors should be analyzed.
• Within the given frame work of constraints objectives are formulated .
• Then based on the objectives securities are selected
• After that the risk and return of the securities should be studied.
• The investors has to assess the major risk categories which they want to minimize.
Compromise or risk and non risk factors has to be carried out.
• Finally relative portfolio weight are assigned to securities like bonds, stocks and
debentures and then diversification is carried out.
 Analysis of Constraints:
Analysis of Constraints:

1.Income: (a) Need of current income

(b) Need of constant income

2.Liquidity:
•If investors desire high liquidity then they will opt high quality short term debt maturity
issues (Such as money market funds, commercial papers and shares that are widely
traded.
•Poorly traded or stocks in closely held business and real estate lack liquidity.
3. Safety of the Principal:
•Serious constraints to be considered by the investor is the safety of the principal value at
the time of liquidation.
•Investing in bonds and debentures is safer than investing in the stocks.
•In stock money should be invested in companies with good historical records and are in
business from long time rather than new.
•Unregistered finance companies may not provide positive result.
 Modern Portfolio Theories:
Portfolio management is concerned with efficient management of investment in the
securities. An investment is defined as the current commitment of funds for a period in
order to derive a future flow of funds that will compensate the investing units.

For a time the funds are committed

For the expected rate of inflation
For the uncertainty involved in the future flow of funds.

•The Modern Portfolio management deals with the process of selection of securities from
the number of opportunities available with different expected returns and carrying
different levels of risk and the selection of securities is made with a view to provide the
investors the maximum yield far a given level of risk or ensure minimise risk for a given
level of return.

•Modern portfolios are constructed to maximize the expected return for a given level of
risk.
•It views portfolio construction in terms of the expected return and the risk associated
with obtaining the expected return.
Continued:

•The Modern Theory proposes how an intelligent investor should use diversification in
order to optimize his or her portfolio returns. The theory also discusses how those assets
that are risky should be priced in the portfolio. The basic concepts of the Modern
Portfolio Theory are Markowitz diversification, capital asset pricing model, the efficient
frontier, the Capital Market Line, the Securities Market Line and the alpha and beta
coefficients.
•The greatest contribution of the theory is believed to be the introduction and
establishment of the risk-return framework while taking decision for investments. The
theory provided the investors with a mathematical approach to portfolio management and
asset selection.

•Modern Portfolio Theory is also popularly known as MPT model. The MPT of economic
theory considers the return of an asset as a random variable and considers the portfolio as
the weighted combination of assets. Hence the return of a portfolio, according to Modern
Portfolio Theory, is defined as the weighted combination of the returns of the assets. The
random variable taking the portfolio's return has an expected value and a variance also.
According to this model, risk is defined as the standard deviation of the return of portfolio
Continued:

•According to MPT model hypotheses, it is assumed that - when the investors are given the
choice of two assets, they will prefer to have the less risky one. Hence it can be said that the
investor will take an asset with higher risk only if he is assured of getting compensation
through high returns. Thus it can be implicated that an intelligent investor will never invest
in a portfolio if there is a second portfolio providing more favourable risk-return profile
features. The investors will always go for portfolio that offers better expected returns.
•According to Modern Portfolio Theory, a quadratic utility function describes the investor's
risk and reward preference. This theory assumes that only the volatility and expected return
of the portfolios matter to the investors. It has been seen that the investors are indifferent
about the skew and kurtosis of the returns. In this theory the volatility is considered as the
proxy for risk and the return is the expectation on the future.
 Markowitz Mean Variance Model:
•Harry Markowitz is regarded as the father of Modern Portfolio Theory. According to him,
Investors are mainly concerned with two properties of an assets, Risk and Return. By
diversification of portfolio it is possible to trade off between them.
•The essence of this theory is that risk of an individual asset hardly matters to an investors.
•What really counts is the contribution it makes to the investors total risk.
•He utilised his principles and converted it into technique for selecting the right portfolio
from range of different assets.
•He developed Mean Variance Analysis in 1952. The thrust has been on balancing safety,
liquidity & return depending on the taste of different investors. According to This approach,
the portfolio selection process is divided into two stages.
(1) Finding the mean variance Efficient portfolio
(2) Selecting one such portfolios

Investors Dislike Risk:

• Simple expectation of the investors that greater the risk greater will be the return.
• Risk and return must be reflected in the required rate of return on investment
opportunities.
 Markowitz Mean Variance Model Continued:
•The Standard Deviation on Variance of Return measures the total risk of an investment
•It is not necessary for investors to accept total risk of an individual security.
•Investor can diversify to reduce risk
•Large numbers of holdings will reduce total risk by diversifications

Assumptions of this Theory:

•The return on an investment adequately summarises the outcome of an investment.

•The investors can visualize a probability distribution of rates of return.
•The investors risk estimate are proportional to the variance of return they perceive for a
security or portfolio
•Investors base their investment decision on two criteria, expected returns and Risk of
returns.
•All investors are risk averse
•Return, Yield has been the most commonly used measures of return
 Markowitz Efficient Frontiers Model:
Markowitz developed this model in order to select a portfolio. In this approach comparison
between a combination of portfolios is estimated. Rule of portfolio says that:-

•A portfolio is not efficient if there is another portfolio with

•A higher expected value of return and lower standard deviation (Risk)
•A higher expected value or return and the same standard deviation (Risk)
•The same expected value but lower standard deviation (Risk)
•Markowitz defined Diversification as the process of combining assets that are less than
perfectly positively correlated in order to reduce portfolio risk without sacrificing any
portfolio return.
•If an investor portfolio is not efficient then he may either
(a) Increase the expected value of return without increasing the risk.
(b) Decrease the risk without decreasing the expected value of return.
(c) Obtain same combination of increase of expected return and decreased risk.
This is possible by switching to a portfolio on the efficient Frontier.
Markowitz Efficient Frontiers Model Continued:
If all securities are pleated on the risk return, individual securities would be dominated by the
portfolio and efficient frontier would be taken shape indicating investments which yield maximum
return given the level of risk bearable. Or which minimise risk givens the expected level of return.

•The best combination of expected return and risk (Std. Deviation) depends upon the
investors utility function
•The Individual investors will want to hold that portfolio of securities that places him to
the highest indifference curve, chasing from the set of portfolios.
•The dark line of the top of the set line of efficient combination as the efficient frontier. It
depict the trade off between risk and expected value of return.
•The optimal investment achieved at a point where the indifference curve is at a target to
the efficient frontier.
•This point of risk is acceptable to the investor (BCD) are the efficient proposal lying on
efficient frontier. (Likeness & Dis-likeness)
Capital Asset Pricing Model (CAPM):
This Model was put forward separately by William Sharpe, Jan Mossin, John Linter
and Jack Treynor. The model was developed upon the earlier theory founded by
Harry Markowitz known as the Portfolio Theory.
The Capital Asset Pricing Model is concerned with finding out the suitable return
rate of an asset when the asset is about to become a part of an existing diversified
portfolio. The (CAPM) is also concerned with the market risk and sensitivity of the
assets regarding these risks.

At the same time, CAPM also considers return from a particular asset that is
theoretically denoted as risk free. Capital Asset Pricing Model categorizes the risk
related to the portfolio in two different types such as systematic risk and
Unsystematic Risk.
These systematic risks cannot be diversified away. It arise out of external and
uncontrollable factors. It denotes the risk factor related with holding the market
portfolio because the fluctuations in the market influence the individual assets also.
The effect in systematic risk causes prices of all individual shares / bonds to move
in the same direction. These movements are generally due to response to economic,
social and political changes and cannot be avoided. It relate to economic trends
which effect whole market.
CAPM Continued:
It cannot be eliminated by diversification of portfolio as all the shares are influenced by
the general market trend. This types of risks arise due to following reasons.
•Interest Rate Risk
•Market Risk
•Recessions
•Purchase Power Risk and War, etc.
Unsystematic Risk: On the other hand unsystematic risk is the portion of total risk
which results from known and controllable factors. Such risk is caused due to factors
unique or related to a firm or industry. They are also known as specific risks. This risk is
specific to individual stocks and cannot be diversified away as the investor increases the
number of stocks in his or her portfolio. In more technical terms, it represent the
components of a stock’s return that is not correlated with general moves.
The unsystematic risk is the change in the price of stocks due to the factors which are
particular stocks. They are unique to particular company or particular investment,
resulting downward movement in the performance of a company. Such unsystematic
risk can not be eliminated through diversification on the part of shareholders. The
systematic risk attached to each of the security is same irrespective of any number of
securities of portfolio. The total risk of portfolio is reduced with increase in number of
stocks as result to decrease in the unsystematic risk distributed over number of stocks in
the portfolio.
CAPM Model Continued:
Unsystematic Risk Arise due to the following reasons:
•Business Risk
•Financial Risk
•Default Risk
Assumption of CAPM:
1. Existence of efficient capital market
2. Investors base their portfolio investment decisions on securities, its expected returns and
standard deviation criteria.
3. Investors, may borrow and lend without limit at risk free rate of interest
4. Investors have identical expectations about the future outcome over a one period time
horizon.
5. All investors have the same expectations about the risk and return
6. Market wide influence that affect all assets to some extent, such as state of economy.
7. No transaction cost
8. Investment goals of investors are rational, investors desire higher return for any acceptable
level of risk or the lowest risk for any desired level of return.
9. Capital market are in equilibrium,
10. There are no taxes or interest rate charges and there is no inflation
11. Investors are risk averse and maximise expected utility of wealth
12. Capital market is not dominated by any individual investors
13. Securities or capital assets face no bankruptcy or insolvency
CAPM Continued:

Thus it is found that Capital Asset Pricing Model holds that all those investors
who are taking systematic risks are compensated by the marketplace. On the
other hand, the marketplace never compensates those investors who are taking
unsystematic or specific risk. The prime reason behind this is that there is a
certain process through which the specific risks can be minimized. A portfolio
consists of different individual assets and each one of these assets implicates
specific risk. By proper use of diversification the specific risks can be managed.

Capital Asset Pricing Model or CAPM holds that the returns that are expected
from a security or the expected returns from a portfolio is in equal proportion
with the combination of a risk premium and the rate on a security that is risk-
free. There are certain situations where the anticipated return from the
investment is not more than the required rate or if the rate is lower than the
required rate, money should not be invested.
 Fisher Black Noise Theory:
According to this theory the market prices of stocks differ from intrinsic values
due to the existence of noise.
Noise implies distorted , incorrect and incomplete information existing in efficient
market
It also include the non uniformity of information access the various market
participants.
In big markets noise are always high.
The market values of stocks differ from values that would arise from the
fundamental analysis by bankers and investors.

.
 Random Walk Hypothesis (RWH):
•Random walk hypothesis states that behaviour of stock market prices is unpredictable and
there is no relationship between the present prices of share and its future prices.
•In short, stock market has no memory
•In 1900 Bachelor has introduced that security price in or organised market might follow a
random walk.
•The term Random Walk in this context is used to refer to successive price changes which
are independent of each other.
•In other words tomorrows price change cannot be predicted by looking at today's price.
•There are no trends in price changes
•Random Walk theory was also tested on companies share prices and it appear to fall a
random walk.
•Theory do not provide an adequate explanation of share price behaviour as the hypothesis is
exclusively concerned with change in price rather than with their levels.
•In this hypothesis the price of share at any point of time consist of a permanent component
and transitory components.
•The RWH is concerned with transitory components.
•The permanent component functionally related to company specific factor such as its
(earning, dividends, assets structure, management efficiency, competitive positions etc.) To
industry specific factors and to other environmental factor such as government policies
towards the industry.
•RWH does not attempt to explain this kind of long term movement in share prices.
 Random Walk Hypothesis (RWH) Continued:
Portfolio analysis provides the input for the next phase in portfolio management which is
portfolio selection. The goal of portfolio construction is to generate a portfolio that provides the
highest returns at a given level of risk. A Portfolio having this characteristics is known as an
efficient portfolio. This inputs from portfolio analysis can be used to identify the set of portfolio
efficient portfolio. From this set of efficient portfolio, the optimal portfolio has to be selected for
investment. The Harry Markowitz's portfolio theory provides both the conceptual framework and
the analytical tools for determining the optimal portfolio in a disciplined and objective way
 Efficient market Hypothesis:
•The Efficient market hypothesis (EMH) is a theory that Capital Markets operate to a high
degree of perfection.
•EMH roots lies in the random Walk Hypothesis, which postulates the share price changes
are of random rather than correlated nature.
•EMH theorists assume that efficient capital markets exists, market with large number of
retail investors and speculators who are trying to maximize profits by predicting future
earning dividends and value of shares.
•Here it is assumed information is known freely to all investors. Spontaneously transmitted
to the market to establish share prices.
•The Price established tends t o be fair price.
•As the market is efficient, the adjustment process tend to allow prices to vary randomly
around the competitive norms.
•According to the efficient market hypothesis, it is not possible to exceed the overall market
with the already known information. The only way that an investor can possibly obtain
higher returns from such a market is by purchasing riskier investments
•The information or news in the efficient market hypothesis is defined as anything that may
affect prices, which is transcendent in the present and thus appears in the future randomly.
According to the EMH, it can also be concluded that the stocks are always traded at their
fair value on stock exchanges.
•Hence, it is impossible for the investors to purchase an undervalued stock or sell the stocks
at inflated prices in such circumstance.
 Form of Market:

In the year (1960) Fama define different markets in terms of their level of efficiency. Where the
level reflected the type or scope of information which was quickly and fully reflected in price..
Fama defined three levels of efficiency, each levels designed to correspond with the different
types of (picking winners) investment strategies which were used in practice to try to achieve
excessive returns.
Weak Form: In this form Prices fully reflect past prices.
Semi Strong Form: This form fully reflect all publically available information relevant to the
share value. E.g.. Company announcement, brokers reports, industry forecast and company
account.
Strong Form: this form Requires all known information to be impounded in the current share
price, weather publically and generally available or not.
Strong form also include insider information e.g. details of impending takeover bid known only
to senior management of both parties to the bid.
 Characteristics of Efficient Market:
•Timely and accurate information on the price and volume of past transactions and on prevailing
supply and demand.
•Liquidity, meaning an asset can be sold or brought quickly at a price close to the price of the
previous transactions assuming no new information has been received.
•Low transaction cost, means that all aspects of the transactions entails low costs.
•Including the cost of reaching the market, the actual brokerage cost involved in the transaction
and the cost of transforming the security.
•Quickly adjustment of prices of securities to the new information

Assumptions of EMH:

•The basic assumption is that in an efficient Capital market, prices of traded securities always
fully reflect all publically available information concerning the securities.
•For market efficiency there are three condition
•All available information is costless to all market participants
•There is no transaction cost and
•All investors take similar views on the implication of available information for current prices
and distribution of future prices of each securities.
 Individual returns and EMH:
•The market which is efficient in quickly reflecting new information prevent investors from
making excess profits using that information
•In a weak form of efficient market , the investors would be unable to pick winners by
locking at charts of past share price or by devising trading rules based on share price
movement.
•In semi Strong Form of efficient market, the investors with access only to publically
available information would not be able consistently to make excess profits by buying
shares. Say an announcement of favorable new information) e.g. if an investor decided to
buy shares on each announcement of unexpectedly high earning, this information would be
available to all and the share prices concerned would quickly reflect that information and
increase.
•In a Strong form of efficient market, no investor would generate excess returns whatever
information he used whether a new analysis of the company accounts or hot tip from the
managing director.

•Since in a market with this level of efficiency share prices would already reflect all
information relevant to shares, whether publically available or not.
 Arbitrage Pricing Model:
•Arbitrage Pricing Mode (APM) is given by Ross in the year 1976
•It look similar to the Capital Asset Pricing Model (CAPM) But Origins are significantly
different
•CAPM is a Single Model and the APM is multi factor model instead of just a single beta value-
•In APM there is whole set of beta values. One for each factor
•The APM Theory states that the expected return on an investment is dependent upon how that
investment reacts to a set of individual macroeconomic factors.
•The degree of reaction is Measures by Beta and the risk premium associated with each of those
macroeconomics factor
•According to Ross that there are four factors which explain the risk / premium relationship of a
particular security.
Some Important factors are :
•Inflation & Money Supply, Industrial Production and Personal Consumption are Interrelated,
•Change in the Level of Industrial Production in the economy,
•Change in the shape of the yield curve,
•Change in the default risk premium,
•Change in the return required on bonds with different perceived risk of Default,
•Change in the Inflation rate,
•Change in the real interest rate, Level of Personal consumption and level of money supply in the
economy.
 Fair Game Concept:
•Through EMH it is seen that ability of investors to pick winners and make excess
returns using new information is directly related to the speed and efficiency of a
market at absorbing that information.
•So efficiency can be considered in term of the fair game concept information in
positive way to investor and investor earn profit and gain by using it.
•The fair game for investors is an outcome of a market being efficient.
•If a market is efficient then investing is a fair game.
Continued:
The.
 Purpose of Portfolio Management:

Portfolio management primarily involves reducing

risk rather than increasing return

Consider two $10,000 investments:

1) Earns 10% per year for each of ten years (low risk)
2) Earns 9%, -11%, 10%, 8%, 12%, 46%, 8%, 20%, -12%,
and 10% in the ten years, respectively (high risk)
 Low Risk vs. High Risk Investments

$30,000
$25,937

$23,642
$20,000
Low
Risk
High
$10,000
$10,000 Risk

$0
'92 '94 '96 '98 '00 '02
 Fisher Black Noice Theory:
According to this theory the market prices of
stocks differ from intrinsic values due to the
existence of noise.
Noise implies distorted , incorrect and
incomplete information existing in efficient
market
It also include the non uniformity of
information access the various market
participants.
In big markets noise are always high.
The market values of stocks differ from values
that would arise from the fundamental analysis