Security Analysis and Portfolio Management Solved Question Paper May 2018
2018 (May)
COMMERCE (Speciality)
Course: 404 (Security Analysis and
Portfolio Management)
Full Marks: 80
Pass Marks: 24 Marks
Time: Three hours
The figures in the margin indicate
full marks for the questions 
1. What do you mean by the following (answer in 1 sentence)? 1x8=8
1) Time
value of money: Time value of money is the concept that the value of a rupee to
be received in future is less than the value of a rupee on hand today.
2) Beta:
Beta attempts to measure an investment's sensitivity to market movements. A
high beta means that an investment is highly volatile and that it will likely
outperform its benchmark in up markets, thus exceeding the benchmark's return,
and underperform it in down markets. A lower beta means an investment is likely
to underperform its benchmark in up markets, but is likely to do better when
the markets fall.
3) Risk:
Risk may
be described as variability/fluctuation/deviation of actual return from
expected return from a given asset/investment. Higher the variability, greater is
the risk. In other words, the more certain the return from an asset, lesser is
the variability and thereby lesser is the risk.
4) Expenditure:
Investment expenditure refers to the expenditure incurred either by an individual or any
financial institutions in the acquisition of various types of investments such
as shares, debentures, bonds etc.
5) Diversification:
Risks involved in investment and portfolio management can be reduced through a
technique called diversification. Diversification is a strategy of investing in a variety of securities in order to
lower the risk involved with putting money into few investments. The
traditional belief is that diversification means “Not putting all eggs in one
basket.” Diversification helps in the reduction of unsystematic risk and
promotes the optimization of returns for a given level of risks in portfolio
management.
6) Portfolio:
A portfolio is
a grouping of financial assets such as stocks, bonds, commodities, currencies
and cash equivalents, as well as their fund counterparts, including mutual,
exchange-traded and closed funds. A portfolio can also consist of non publicly tradable
securities, like real estate, art, and private investments.
7) Security
market line (SML) is the representation of the Capital asset pricing model. It
displays the expected rate of return of an individual security as a function of
systematic, non-diversifiable risk (its beta). It is also referred to as the
"characteristic line".
👉Also Read: Dibrugarh University SAPM Solved Question Papers
2.
Write short notes on the following (any four): 4x4=16
a)
Unsystematic risk: Unsystematic Risk refers to that portion of
total risk that is unique or peculiar to a firm or an industry, above and
beyond that affecting securities markets in general. Factors like consumer
preferences, labour strikes, management capability etc. cause unsystematic risk
(variability of returns) for a company’s stock. Unlike systematic risk, the
unsystematic risk can be reduced/avoided through diversification. Total risk of
a fully diversified portfolio equals to the market risk of the portfolio as its
specific risk becomes zero.
b) Traditional portfolio analysis:
Traditional portfolio analysis has been of a very subjective nature for each
individual. The investors made the analysis of individual securities through
the evaluation of risk and return conditions in each security. The normal
method of finding the return on an individual security was by finding out the
amounts of dividends that have been given by the company, the price earning
ratios, the common holding period and by an estimation of the market value of
the shares. The traditional theory assumes that selection of securities should
be based on lowest risk as measured by its standard deviation from the mean of
expect returns. The greater the variability of returns the greater is the risk.
Thus, the investor chooses assets with the lowest variability of returns.
c) Capital
Market Line (CML): Capital Market Line (CML) is a line used in the capital
asset pricing model to illustrate the rates of return for efficient portfolios
depending on the risk-free rate of return and the level of risk (standard
deviation) for a particular portfolio.
The CML is derived by drawing a tangent line
from the intercept point on the efficient frontier to the point where the
expected return equals the risk-free rate of return. The CML is considered to
be superior to the efficient frontier since it takes into account the inclusion
of a risk-free asset in the portfolio.
The CML is the relationship between the risk
and the expected return for portfolio. The CML results from the combination of
the market portfolio and the risk-free asset. 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, this portfolio 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.
d) Jensen Model: Jensen's model
proposes another risk adjusted performance measure. This measure was developed
by Michael Jensen and is sometimes referred to as the Differential Return
Method. This measure involves evaluation of the returns that the fund has
generated vs. the returns actually expected out of the fund given the level of
its systematic risk. The surplus between the two returns is called Alpha, which
measures the performance of a fund compared with the actual returns over the
period. Required return of a fund at a given level of risk (b) can be
calculated as:
Rt – R = a + b (Rm
– R)
Where,
Rt = Portfolio Return
R = Risk
less return
a =
Intercept the graph that measures the forecasting ability of the portfolio
manager.
b = Beta
coefficient, a measure of systematic risk
Rm
= Return of the market portfolio
Thus, Jensen’s equation involves two steps:
(i) First he calculates what the return of a
given portfolio should be on the basis of b, Rm and R.
(ii) He compares the actual realised return of
the portfolio with the calculated or predicted return. Greater the excess of
realised return over the calculated return, better is the performance of the
portfolio.
Limitation of this model is that it considers
only systematic risk not the entire risk associated with the fund and an
ordinary investor can not mitigate unsystematic risk, as his knowledge of
market is primitive.
e)
Efficient Market: In an efficient market, all the
relevant information is reflected in the current stock price. Information
cannot be used to obtain excess return: the information has already been taken
into account and absorbed in the prices. Tests of the market efficiency are
tests of whether the three general types of information – past prices, other
public information and inside information can be used to make above-average
returns on investments. These tests of market efficiency have also been termed
as weak-form (price information), semi strong form (other public information)
and strong form (inside information) tests.
3.
What do you mean by fundamental analysis and technical analysis? Bring out
clearly the points of distinction between the two. 8+6=14
Ans: Meaning of fundamental analysis
Fundamental analysis is method of
finding out the future price of a stock which an investor wishes to buy.
Fundamental analysis is used to determine the intrinsic value of the share of a
company to find out whether it is overpriced or under priced by examining the
underlying forces that affect the well being of the economy, Industry groups
and companies.
Fundamental analysis is simply an
examination of future earnings potential of a company, by looking into various
factors that impact the performance of the company. The prime objective of a
fundamental analysis is to value the stock and accordingly buy and sell the
stocks on the basis of its valuation in the market. The fundamental analysis
consists of economic, industry and company analysis. This approach is sometimes
referred to as a top-down method of analysis.
Meaning of
technical analysis
In fundamental analysis, a value of a
stock is predicted with risk-return framework based on economic environment. An
alternative approach to predict stock price behaviour is known as technical
analysis. It is frequently used as a supplement rather than as a substitute to
fundamental analysis. Technical analysis is based on notion that security
prices are determined by the supply of and demand for securities. It uses
historical financial data on charts to find meaningful patterns, and using the
patterns to predict future prices.
In the words of Edwards and Magee:
“Technical analysis is directed towards predicting the price of a security. The
price at which a buyer and seller settle a deal is considered to be the one
precise figure which synthesizes, weights and finally expresses all factors,
rational and irrational quantifiable and non-quantifiable and is the only
figure that counts”.
Difference between technical and
fundamental analysis
The key differences between technical
analysis and fundamental analysis are as follows:
1.
Technical analysis mainly seeks to
predict short term price movements, whereas fundamental analysis tries to
establish long term values.
2. The
focus of technical analysis is mainly on internal market data, particularly
price and volume data. The focus of fundamental analysis is on fundamental
factors relating to the economy, the industry, and the firm.
3. Technical
analysis appeals mostly to short-term traders i.e. speculators, whereas
fundamental analysis appeals primarily to long-term investors.
4. Technical
analysis is the a simple and quick method on forecasting behaviour of stock
prices. Whereas, fundamental analysis involves compilation and analysis of huge
amount of data and is therefore, complex, time consuming and tedious in nature.
5.
The technical analysis is based on the
premise that the history repeats itself. Therefore, the technical analysis
answers the question “What had happened in the market” while on the basis of
potentialities of market fundamental analysis answers the question, “What will
happen in the market”.
6.
The technical analysis assumes that
the market is 90 percent psychological and 10 percent logical, while the
fundamental analysis believes that the market is 90 percent logical and
10percent psychological.
7.
The technical analysis seeks to
estimate security prices rather than values, while the fundamental analysis
estimates the intrinsic value of a security.
8. According
to technical analysts, their method is far superior than the fundamental
analysis, because fundamental analysis is based on financial statements which
themselves are plagued by certain deficiencies like subjectivity, inadequate
disclosure etc.
Or
Define
the term ‘investment’. Discuss the different avenues available to an investor
for making investment. 4+10=14
Ans: MEANING OF
INVESTMENT
Investment is the employment of funds
with the aim of getting return on it. In general terms, investment means the
use of money in the hope of making more money. In finance, investment means the
purchase of a financial product or other item of value with an expectation of
favorable future returns.
Investment of hard earned money is a
crucial activity of every human being. Investment is the commitment of funds
which have been saved from current consumption with the hope that some benefits
will be received in future. Thus, it is a reward for waiting for money. Savings
of the people are invested in assets depending on their risk and return
demands.
Investment refers
to the concept of deferred consumption, which involves purchasing an asset, giving
a loan or keeping funds in a bank account with the aim of generating future
returns. Various investment options are available, offering differing
risk-reward tradeoffs. An understanding of the core concepts and a thorough
analysis of the options can help an investor create a portfolio that maximizes
returns while minimizing risk exposure.
INVESTMENT
ALTERNATIVES
Wide varieties of investment avenues
are now available in India. An investor can himself select the best avenue
after studying the merits and demerits of different avenues. Even financial
advertisements, newspaper supplements on financial matters and investment
journals offer guidance to investors in the selection of suitable investment
avenues. Investment avenues are the outlets of funds. A wide range of
investment alternatives are available, they fall into two broad categories,
viz, financial assets and real assets. Financial assets are paper (or
electronic) claim on some issuer such as the government or a corporate body.
The important financial assets are equity shares, corporate debentures,
government securities, deposit with banks, post office schemes, mutual fund
shares, insurance policies, and derivative instruments. Real assets are
represented by tangible assets like residential house, commercial property,
agricultural farm, gold, precious stones, and art object. As the economy
advances, the relative importance of financial assets tends to increase. Some
of the important investment alternatives are given below:
a)
Non-marketable Financial Assets:
A good portion of financial assets is represented by non-marketable financial
assets. A distinguishing feature of these assets is that they represent
personal transactions between the investor and the issuer. For example, when
you open a savings bank account at a bank you deal with the bank personally. In
contrast when you buy equity shares in the stock market you do not know who the
seller is and you do not care. These can be classified into the following broad
categories:
1) Post
office deposits
2) Company
deposits
3) Provident
fund deposits
4) Bank deposits
b)
Equity
shares: By
investing in shares, investors basically buy the ownership right to that
company. When the company makes profits, shareholders receive their share of
the profits in the form of dividends. In addition, when a company performs well
and the future expectation from the company is very high, the price of the
company’s shares goes up in the market. This allows shareholders to sell shares
at profit, leading to capital gains. Investors can invest in shares either
through primary market offerings or in the secondary market.
c)
Preference Shares: Preference
shares refer to a form of shares that lie in between pure equity and debt. They
have the characteristic of ownership rights while retaining the privilege of a
consistent return on investment. The claims of these holders carry higher
priority than that of ordinary shareholders but lower than that of debt
holders. These are issued to the general public only after a public issue of
ordinary shares.
d)
Debentures
and Bonds: These
are essentially long-term debt instruments. Many types of debentures and bonds
have been structured to suit investors with different time needs. Debentures
and Bonds are the
instruments that are considered as a relatively safer investment avenues.
Though having a higher risk as compared to bank fixed deposits, bonds, and
debentures do offer higher returns.
e)
Mutual Fund Schemes: The
Unit Trust of India is the first mutual fund in the country. A number of
commercial banks and financial institutions have also set up mutual funds.
Mutual funds have been set up in the private sector also. These mutual funds
offer various investment schemes to investors. The number of mutual funds that
have cropped up in recent years is quite large and though, on an average, the
mutual fund industry has not been showing good returns, select funds have
performed consistently, assuring the investor better returns and lower risk
options.
f)
Money
market instrument:
By convention, the term "money market" refers to the market for
short-term requirement and deployment of funds. Money market instruments are
those instruments, which have a maturity period of less than one year. Examples
of money market instruments are T-Bills, Certificate of Deposit, Commercial
Paper etc.
g)
Life
insurance: Now-a-days life
insurance is also being considered as an investment avenue. Insurance premiums
represent the sacrifice and the assured sum the benefit. Under it different
schemes are:
1) Endowment assurance policy
2) Money back policy
3) Whole life policy
4) Term assurance policy
h) Real
estate: With the ever-increasing cost of land, real
estate has come up as a profitable investment proposition.
i)
Bullion Investment: The
bullion market offers investment opportunity in the form of gold, silver, and
other metals. Specific categories of metals are traded in the metals exchange.
The bullion market presents an opportunity for an investor by offering returns
and end value in future. It has been observed that on several occasions, when
the stock market failed, the gold market provided a return on investments.
j)
Financial
Derivatives: These are such
instruments which derive their value from some other underlying assets. It may
be viewed as a side bet on the asset. The most important financial derivatives
from the point of view of investors are Options and Futures.
4.
Discuss the need and significance of diversification in a portfolio
construction. 14
Ans: Diversification:
Risks involved in investment and portfolio management can be reduced through a
technique called diversification. Diversification is a strategy of investing in a variety of securities in order to
lower the risk involved with putting money into few investments. The
traditional belief is that diversification means “Not putting all eggs in one
basket.” Diversification helps in the reduction of unsystematic risk and
promotes the optimization of returns for a given level of risks in portfolio
management.
Diversification may take any of the following
forms:
a) Different
Assets e.g. gold, bullion, real estate, government securities etc.
b) Different
Instruments e.g. Shares, Debentures, Bonds, etc.
c) Different
Industries e.g. Textiles, IT, Pharmaceuticals, etc.
d) Different
Companies e.g. new companies, new product company’s etc.
Proper diversification involves two or
more companies/industries whose fortunes fluctuate independent of one another
or in different directions. One single company/industry is always more risky
than two companies/industries. Two company’s in textile industry are more risky
than one company in textile and one in IT sector two companies/industries which
are similar in nature of demand a market are more risky than two in dissimilar
industries.
Importance
of Diversification in Portfolio Management
Diversification of
investments is significant due to the following reasons:
1. Reduce the risk: Every stock or financial instrument carries some
amount of risk with it except the risk-free investments. With portfolio
diversification, one cannot completely remove the risks but can reduce the risk
to a great extent. Without proper diversification amongst the different classes
of the assets, the risk of investment rises with every investment we make. One
needs to include both risky asset classes such as high- return generating
stocks and to hedge their risk they should invest in fixed income assets.
Diversification gradually reduces the risk of the portfolio over time.
2. Helps In Hedging: If investments are
entirely made in stock market, then in case of excessive volatility the return
on investments will dropped significantly. However, if they investors kept a
certain amount of other investment assets like commodities, bonds, metals in
their portfolio, their profits would have been higher because loss or low profits
of the stock market would have been wiped off by the positive returns of the
commodities market. Diversification helps in achieving desired or better
returns even when the market is slow as there are other markets which make up
for the negative or low yields of the former market. This way investors can
hedge their investments and earn potential returns through portfolio
diversification.
3. Provide Higher Returns: Since the market
keeps on changing, we need to diversify with asset classes which are not
correlated. Correlation plays the most critical role in determining returns. If
we are investing in one market which is connected to the other, when the former
goes down, that will substantially affect the other. We need to choose
investment vehicles which are entirely different from each other. That’s why we
need a diversified portfolio.
4. Aligning Portfolio With Financial Aspirations: As per the Behavioural portfolio theory, either our investment will
give us the potential for high-growth, or it will protect from negative
returns. This theory states that when a portfolio is diversified, it
corresponds to a pyramid structure. A properly diversified portfolio has the
maximum of low-risk investments and provides value growth and steady income
generation. ‘Blend’ funds comprise the top of this pyramid which is a mix of
risky and low-risk investment instruments. The regular income generating
investments will provide with periodic income, and the blend funds will grow in
value, and together they bring stability of investment and higher wealth
accumulation.
5. Investment Mix Adjustment: Portfolio
diversification allows us to modify investment mix as per changing financial
needs and market changes. With age, the investment mix also needs to be changed
as the tenure for investments keeps on reducing. While we start off with
high-risk investment instruments, with time flowing, we must reduce our risk by
shifting more towards fixed income financial instruments for regular earnings.
While an investor of 20’s age group can assign 90% of his investment into
stocks, investor of 50’s age group must have not more than 40% allocated to
equities. That’s why we need a diversified portfolio.
Or
Explain the Markowitz portfolio theory. What are the
assumptions of Markowitz portfolio theory? 6+8=14
Ans: MARKOWITZ MODEL
Dr. Harry M. Markowitz was the person
who developed the first modern portfolio analysis model. Markowitz used
mathematical programming and statistical analysis in order to arrange for the
optimum allocation of assets within portfolio. He infused a high degree of
sophistication into portfolio construction by developing a mean-variance model
for the selection of portfolio. Markowitz approach determines for the investors
the efficient set of portfolio through three importance variables - Return,
standard deviation and coefficient of correlation.
Markowitz model is called the “Full
Covariance Model”. Through this method the investor can find out the efficient
set of portfolio by finding out the trade off between risk and return, between
the limits of zero and infinity. Markowitz theory is based on several
assumptions these are:
PARAMETERS
OF MARKOWITZ DIVERSIFICATION
Based on thorough and scientific
research, Markowitz has set down his own guidelines for diversification:
a) The
investments have different types of risk characteristics. Some are systematic
or market related risks and the others are unsystematic or company related
risks.
b) His
diversification involves a proper number of securities not too less nor too
many.
c) The
securities have no correlation or negative correlation.
d) Last
is the proper choice of the companies, securities or assets whose returns are
not related and whose risks are mutually off setting to reduce the overall
risk.
Markowitz lays down three parameters
for building up the efficient set of portfolio:
a) Expected
returns.
b) Standard
deviation from mean to measure variability of returns.
c) Covariance
or variance of one asset return to other asset returns.
To generalize, higher the expected
return, lower will be the standard deviation or variance and lower is the
correlation. In such a case, better will be the security for investor choice.
If the covariance of the securities’ returns is negative or negligible, the
total risk of the portfolio of all securities may be lower as compared to the
risk of the individual securities in isolation.
By developing his model, Markowitz
first did away with the investment behaviour rule that the investor should
maximize expected return. This rule implied that the non-diversified single
security portfolio with the highest expected return is the most desirable
portfolio. Only by buying that single security can expected return be
maximized. The single security portfolio can be much preferred if the higher
return turns out to be the actual return. However, in real world, there are
conditions of so much uncertainty that most risk averse investors, joint with
Markowitz in adopting diversification of securities.
ASSUMPTIONS
OF MARKOWITZ’S MODEL
a) The
markets are efficient and absorb all the information quickly and perfectly. So
an investor can earn superior returns either by technical analysis or
fundamental analysis. All the investors are in equal category in this regard.
b) Investors
are risk averse. Before making any investments, all of them, have a common
goal-avoidance of risk.
c) Investors
are rational. They would like to earn the maximum rate of return with a given
level of income or money.
d) Investors
base their decisions solely on expected return and variance (or standard
deviation) of returns only.
e) For
a given risk level, investors prefer high returns to lower returns. Similarly,
for a given level of expected return, they prefer less risk to more risk.
f)
The investor can reduce the risk if he
adds investments to his portfolio.
g) Investors
consider each investment alternative as being represented by a probability
distribution of expected returns over some holding period.
h) A
portfolio of assets under the above assumptions is considered to be efficient
if no other portfolio of assets offers higher expected return with the same (or
lower) risk or lower risk with the same (or higher) expected return.
5.
What are the basic assumptions of CAPM? Write down the difference between CAPM
and APT model. 6+8=14
Ans: Assumptions of CAPM
The capital asset pricing model is
based on certain explicit assumptions regarding the behavior of investors. The
assumptions are listed below:
1. Investor
make their investment decisions on the basis of risk-return assessments
measured in terms of expected returns and standard deviation of return.
2. The
purchase or sale of a security can be undertaken in infinitely divisible unit.
3. Purchase
and sale by a single investor cannot affect prices. This means that there is
perfect competition where investors in total determine prices by their action.
4. There
are no transaction costs. Given the fact that transaction costs are small, they
are probably of minor importance in investment decision-making, and hence they
are ignored.
5. There
are no personal income taxes. Alternatively, the tax rate on dividend income
and capital gains are the same, thereby making the investor indifferent to the
form in which the return on the investment is received (dividends or capital
gains).
6. The
investor can lend or borrow any amount of fund desired at a rate of interest
equal to the rate of risk less securities.
7. The
investor can sell short any amount of any shares.
8. Investors
share homogeneity of expectations. This implies that investors have identical
expectations with regard to the decision period and decision inputs. Investors
are presumed to have identical expectations regarding expected returns,
variance of expected returns and covariance of all pairs of securities.
Difference
between APT and CAPM
a) APT
computes the expected return on a security based on the security’s sensitivity
to movements in macroeconomic factors. Whereas, CAPM
is a tool used by investors to determine the risk associated with a potential
investment and also gives an idea as to what can be the expected return on the
investment.
b) The
APT can be set up to consider several risk factors, such as the business cycle,
interest rates, inflation rates, and energy prices. The model distinguishes
between systematic risk and firm-specific risk and incorporates both types of
risk into the model for each given factor. Where as CAPM considers only systematic risk,
reflecting a reality in which most investors have diversified portfolios from
which unsystematic risk has been essentially eliminated.
c) APT
is based on factor model of return and arbitrage Whereas CAPM is based on
investors’ portfolio demand and equilibrium.
d) APT
is a multifactor model where as CAPM is a single factor model.
e) APT
places emphasis on covariance between asset returns and exogenous factors
whereas CAPM places emphasis on covariance between asset returns and endogenous
factors.
f)
APT model works better in multi period
cases as against CAPM which is suitable for single period cases only.
Or
GAIL Investment Company
manages a portfolio consisting of 6 stock with the following information:
|
Name of the scrip |
Market value (Rs.) |
Beta |
|
Essar Steels Ltd. TATA Steels Ltd. SAIL Ltd. Andhra Steels Ltd. Mittal Steels Ltd. Varun Steels Ltd. |
4,00,000 3,00,000 3,00,000 1,00,000 2,00,000 2,00,000 |
1.20 1.24 0.90 0.60 0.75 0.80 |
The risk-free rate of interest is 6 percent
and the market return is 13 percent. Estimate the portfolio expected return and
portfolio beta. 8+6=14
6.
Explain the different methods of measurement of portfolio performance. 14
Ans: Portfolio performance evaluation and methods of its assessment
Portfolio performance evaluation can
be defined as a feedback and control mechanism which is used by the portfolio
managers and investment analysts to make the process of portfolio/investment
management more effective. Expert Portfolio managers have to show superior
performance over the market; for that they have to evaluate their performance
in comparison with other portfolio managers. Portfolio manager have an
objective to achieve an optimum risk return adjustment. Whether they are
heading towards this objective or not will be found out only if they evaluate
their portfolios periodically. However, in conducting such an evaluation, a
means for determining the appropriate standard or benchmark must be
established. Two major factors which influence the performance are the rate of
return earned and the associated risk over the relevant period. The return is
defined to include changes in the value of the fund over the performance period
plus any income earned over that period. Risk is the variability surrounding
the return. The manager has to diversify completely into different industries,
assets and instruments so as to reduce the unsystematic risk to the minimum for
a given level of return. The systematic or market related risk has to be
managed by a proper selection of beta for the securities.
Methods
of assessing performance
The portfolio performance is evaluated
by measuring and comparing the portfolio return and associated risk and hence
risks adjusted performance. For this purpose, there are essentially three major
methods of assessing performance:
a) Return
per unit of risk.
b) Differential
return.
c) Components
of performance.
a) Return per Unit of Risk:
The first measure of risk adjusted performance assesses the performance of a
fund in terms of return per unit of risk; both in absolute terms and relative
terms (relative to overall market performance). According to this measure,
funds that provide the highest return per unit of risk would be adjudged as the
best performers and the funds that provide the lowest return per unit of risk
would be the poorest performers. There are two methods of determining the
return per unit of risk.
Ø Reward
to volatility ratio developed by William Sharpe and
Ø Reward
to volatility ration developed by Jack Treynor.
Evaluation has also to take into
account whether the portfolio is securing above average returns, average returns
or below average returns as compared to the prevailing rate of return in the
market. The ability of the fund managers to diversity can reduce and even
eliminate all unsystematic risk. They can manage the systematic risk by use of
appropriate risk measures, namely Betas. The portfolio managers must have
superior timing and superior stock selection to earn above average returns.
Diversification can reduce the market related risk and maximize the returns for
a given level of risk. As the market returns are positively related to risk,
the evaluators must take into consideration (a) The rate of returns, (b) Excess
return over risk free rate, (c) Level of systematic, unsystematic and residual
risk through proper diversification.
b) Differential Return:
Another method to measure the risk adjusted performance is the differential
return measure. This measure was developed by Michael Jensen. The basic
objective of this technique is to calculate the return that should be expected
for the fund given the realized risk of the fund and then comparing the
calculated return with the actually realized return. In making this comparison,
it is assumed that the investor plays a very passive role. He merely buys the
market portfolio and adjusts for the appropriate level of risk by borrowing or
lending at the risk free rate.
c) Components of Performance:
The first two measures stated above are primarily concerned with the overall
performance of a fund. However, the more useful measure would be to assess the
sources and components of performance by developing a more refined breakdown.
E. Fama has provided an analytical framework to have a more detailed break down
of the performance of the fund. This break down is done in the following three
ways:
1.
Stock
Selection: Overall performance of the fund can be
examined in terms of superior or inferior stock selection and the normal return
associated with a given level of risk. Thus, Total Excess Return = Selecting +
Risk.
To earn average returns, the fund
managers have to diversify. The market pays returns only on the basis of
systematic risk. The level of diversification can be judged on the basis of the
correlation between the portfolio returns and the returns for a market
portfolio. A completely diversified portfolio is perfectly correlated with the
market portfolio, which is in turn completely diversified.
To earn the above average return, fund
managers will generally have to forsake some diversification that will have its
cost in terms of additional portfolio risk. Hence some additional return is
needed for this additional diversification risk. Capital Market Line (CML)
helps in determining the risk commensurate with the incurred risk.
2. Market Timing:
If investors want to maximize their returns, they must not only purchase the
right security but must also know the right time to purchase and sell. To
generate superior performance better than the market average, markets, have to
be timed correctly. Market timing implies assessing correctly the direction of
the market, either bull or bear and positioning the portfolio accordingly. When
there is a forecast of declining market, the managers should position the
portfolio properly by increasing the cash percentage of the portfolio or by
decreasing the beta of the equity portion of the portfolio. When the forecast
is of rising market, the managers should decrease the cash position or increase
the beta of the equity portion of the portfolio.
3. Cash Management Analysis:
Cash management analysis was used by Farrell to assess the degree to which
variations in the cash percentage around the long term average have benefited
or detracted from fund performance. Two indexes were constructed for each fund
by Farrell:
Ø The
first index is based on the average cash to other asset allocation experienced
by the fund over the period of analysis.
Ø The
second index is based on a quarter to quarter changes experienced by the fund
over the period.
Or
The financial performance
of the various mutual funds is provided below. The risk-free rate of interest
is 6%:
|
Name of the scheme |
Return On Portfolio |
Standard Deviation Of the Portfolio |
Beta |
|
Birla Mutual Fund TATA Mutual Fund ICICI Mutual Fund |
23.45 22.95 23.15 |
0.3 8.98 3.45 |
0.27 0.54 0.56 |
Rank the funds according to
the Sharpe and Treynor Performance Index. 7+7=14
Post a Comment
Kindly give your valuable feedback to improve this website.