Security Analysis and Portfolio Management Solved Question Paper May 2014
2014 (May)
COMMERCE (Speciality)
Course: 404 (Security Analysis and
Portfolio Management)
Full Marks: 80
Pass Marks: 32 Marks (Old Course)
Time: Three hours
The figures in the margin indicate
full marks for the questions
The figures in the margin indicate full marks for the questions.
1. What do you mean by the following
(in one sentence only)? 1x8=8
a) Investment.
Ans:
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.
b) Diversification.
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.
c) Risk.
Ans: 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.
d) Option.
(Out of Syllabus)
e) Market
timing.
Ans: .
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.
f) Convertible
securities.
Convertible
security: A convertible security is a type of security, usually a bond or a
preferred stock, that can be converted into a different form of security,
normally equity shares.
g) Portfolio.
Ans: Portfolio
refers to the allocation of funds among a variety of financial assets available
for investment.
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2. Write short notes on the following:
4x4=16
a) Future market. (Out of syllabus)
b) Factor
models.
Ans: Factor Models: In
portfolio management computation of expected return, risk and covariance for
every security included in the portfolio is crucial process and it proves a bit
difficult too. Factor
models relatively make the process easier as security return is assumed to be
in correlation with one factor(s) or other(s). Factor models captured macro
economic factors that systematically influence prices of
securities. Any aspect of a
security’s return unexplained by the factor model is taken as security
specific. Factor models are otherwise known as index models. Securities return when
assumed to be related to return on a market index, such model is called as
market index model. Similar to return on market index, other factors to which
security returns stand related can be modeled and used to estimate returns as
securities. Similarly portfolio returns as related to identified factors can be
found and used in portfolio management. And this will ease the
problem of computing returns. One
factor (say Market Return, Growth rate of gross Domestic Product or Inflation rate), two factors (any two of
macro economic factors) and multi-factors models can be through of.
Single Factor Model
CAPM is base on the single factor model.
According to this model, the asset price depends on a single factor, say gross
national product or industrial productions or interest rates, money supply and
so on. In general, a single factor model can be represented in the equation
form as follows:
R = E + Bf + e
Where, E = Uncertain return on security
B = Security’s sensitivity to change in the
factor
f = The actual return on the factor
e = error term
Thus, this model only state that the actual
return on a security equals the expected return plus sensitivity times factor
movement plus residual risk.
Multiple
Factor Model
The Arbitrage pricing theory based model aims to do away with the
limitations of one factor model (CAPM) that different stocks will have
different sensitivities to different market factors which may be totally
different from any other stock under observation. In layman terms, one can say
that not all stocks can be assumed to react to single and same parameter always
and hence the need to take multifactor and their sensitivities. The formula
includes a variable for each factor, and then a factor beta for each factor,
representing the security’s sensitivity to movements in that factor. A
two-factor version of the arbitrage pricing theory would look like as:
r = E(r) + B1F1 + B2F2 +
e
r = return on the security
E(r) = expected return on the security
F1 = the first factor
B1 = the security’s
sensitivity to movements in the first factor
F2 = the second factor
B2 = the security’s
sensitivity to movements in the second factor
e = the idiosyncratic component of the security’s return
As the formula shows, the expected return on the asset/stock is a
form of liner regression taking into consideration many factors that can affect
the price of the asset and the degree to which it can affect it i.e. the
asset’s sensitivity to those factors.
c) Fundamental
analysis.
Ans:
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.
Types of
fundamental analysis to be done before making Investment
The actual value of a security, as opposed to its market price or
book value is called intrinsic value. The intrinsic value includes other
variables such as brand name, trademarks, and copyrights that are often
difficult to calculate and sometimes not accurately reflected in the market
price. One way to look at it is that the market capitalization is the price
(i.e. what investors are willing to pay for the company and intrinsic value is
the value (i.e. what the company is really worth). The fundamental analysis
consists of economic, industry and company analysis. This approach is sometimes
referred to as a top-down method of analysis.
a)
At the economy level, fundamental
analysis focus on economic data (such as GDP, Foreign exchange and Inflation
etc.) to assess the present and future growth of the economy.
b)
At the industry level, fundamental
analysis examines the supply and demand forces for the products offered.
c)
At the company level, fundamental
analysis examines the financial data (such as balance sheet, income statement
and cash flow statement etc.), management, business concept and competition.
d) Fixed
securities.
Ans: Fixed
Securities: Fixed securities also known as fixed income
securities refers to those investments that provides their owners fixed rate of
income irrespective of market forces. Risks in case of fixed securities are
minimum and returns are also low as compared to common stock. Classic examples
of fixed securities are debentures and bonds.
Bonds/debentures are instrument of debt issued
by a business house or a government unit against the floating charge of its
assets. The bonds/debentures may be issued at par, premium or discount. The par
value is the amount stated on the face of the bond/debentures. It states the
amount the firm borrows and promises to repay at the time of maturity. The
bonds/debentures carry a fixed rate of interest payable at fixed intervals of
time. The interest is calculated by multiplying the value of bonds with rate of
interest.
3. (a) Discuss the different avenues
available to an investor for making investments. 11
Ans: Different
methods of the classification of the investment avenues are available. Some of
the methods are as follows:
1.
Physical Investments: Physical
investments are tangible assets like motorcars, aero planes, ships, buildings,
plant and machinery etc. some of the physical assets like machinery, equipment
etc. are useful for further production whereas some like gold and silver
ornaments, motor cars etc. are not useful for further production.
2.
Financial Investment: Financial assets
are those which are used for consumption or for production of goods and
services or for further creation of assets. Examples are shares, NSS certificates,
bonds, etc.
3.
Marketable and Non-Marketable
Investments: Some investments which are listed on the stock exchanges are
easily marketable and can converted into cash in a short time e.g. shares,
bonds and other instruments issues by government or companies. Non-marketable
investments like bank deposits, provident funds, insurance schemes etc. cannot
be bought or sold in the open market in the stock exchanges and thus are
difficult to be converted into cash immediately.
4.
Transferable and Non-Transferable:
Instruments like shares, bonds can be transferred in the name of others or can
be sold or exchanged for cash or kind, whereas some instruments like insurance
certificates, NSCs, cannot be transferred.
Investments
Avenues
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.
Or
(b) What
do you mean by technical analysis? Differentiate between technical analysis and
fundamental analysis. 4+7=11
Ans:
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”.
Edwards and Magee formulate the basic assumptions underlying
technical analysis which are as follows:
1.
The market value of the scrip is
determined by the interaction of demand and supply.
2.
Supply and demand is governed by
numerous factors, both rational and irrational. These factors include economic
variables relied by the fundamental analysis as well as opinions, moods and
guesses.
3.
The market discounts everything. The
price of the security quoted represents the hope, fears and inside information
received by the market players. Insider information regarding the issuance of
bonus shares and right issues may support the prices. The loss of earnings and
information regarding the forthcoming labor problem may result in fall in
price. These factors may cause a shift in demand and supply, changing the
direction of trends.
4.
The market always moves in the trends
except for minor deviations.
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.
4. (a) How
can risk of an asset be calculated? Write a note on the diversification of
risk. 2+10=12
Ans: Risk can be defined as the combination of the probability of
an event occurring and the consequences if that event does occur. This gives us
a simple formula to measure the level of risk in any situation. Risk =
Likelihood x Severity.
Diversification
of Risk
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.
Some
accepted methods of effecting diversification are as follows:
a)
Random
Diversification: Randomness is a statistical technique which
involves placing of companies in any order and picking them up in random
manner. The probability of choosing wrong companies will come down due to
randomness and the probability of reducing risk will be more. Some experts have
suggested that diversification at random does not bring the expected return
results. Diversification should, therefore, be related to industries which are not
related to each other.
b)
Optimum
Number of Companies: The investor should try to find the
optimum number of companies in which to invest the money. If the number of
companies is too small, risk cannot be reduced adequately and if the number of
companies is too large, there will be diseconomies of scale. More supervision
and monitoring will be required and analysis will be more difficult, which will
increase the risk again.
c)
Adequate
Diversification: An intelligent investor has to choose not
only the optimum number of securities but the right kind of securities also.
Otherwise, even if there are a large number of companies, the risk may not be
reduced adequately if the companies are positively correlated with each other
and the market. In such a case, all of them will move in the same direction and
many risks will increase instead of being reduced.
d)
Markowitz
Diversification: Markowitz theory is also based on
diversification. According to this theory, the effect of one security purchase
over the effects of the other security purchase is taken into consideration and
then the results are evaluated.
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.
Problems
of Diversification
Investment in too many assets may lead to the
following problems:
1)
Purchase of bad stocks. While buying
stocks at random, sometimes, the investor may purchase certain stocks which
will not yield the expected return.
2)
Difficulty in obtaining information.
When there are too many securities in a portfolio, it becomes difficult for the
portfolio manager to obtain detailed information about their performance. In
the absence of information he may not provide right advice as to what to buy
and what not to buy.
3)
Increased research cost. Before the
purchase of stocks, detailed analysis as to economic and technical performance
of individual stock has to be carried out. This requires collecting and
processing of information and storing the same. These procedures involve high
costs in terms of salaries to be paid to the analysts who are specialized
people in this field.
4)
Increased transaction cost. Some cost
has to be incurred whenever a stock is to be purchased. Purchasing stocks in
small quantities frequently involves higher transaction cost than the purchase
of large quantity in one go.
Or
(b) What
do you understand by Portfolio Management? Write a note on the time value of
money. 4+8=12
Ans:
Portfolio management: Portfolio management is a dynamic
concept and requires continuous and systematic analysis, judgement and
operations. It is a process involving many activities of investment in assets
and securities. Firstly, it involves construction of a portfolio based upon the
data base of the client/investor, his objectives, constraint preferences for
risk and return etc. On the basis of above mentioned facts, selection of assets
and securities is made. Secondly, it involves monitoring/reviewing of the
portfolio from time to time in light of changing market conditions.
Accordingly, changes are effected in the portfolio. Thirdly, it involves
evaluation of the portfolio in terms of targets set for risk and return and
making adjustments accordingly.
Basically, portfolio management involves a
proper decision making as to what to purchase and what to sell. It requires
detailed risk and return analysis and proper money management in terms of
investments in a basket of assets, the basic objective being reduction of risk
and maximization or return.
Time
Value of Money (TVM)
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. One reason
is that money received today can be invested thus generating more money in near
future. Another reason is that when a person opts to receive a sum of money in
future rather than today, he is effectively lending the money and there are
risks involved in lending such as default risk and inflation. Default risk
arises when the borrower does not pay the money back to the lender. Inflation
is the rise in general level of prices.
Time value of money principle also applies when comparing the
worth of money to be received in future and the worth of money to be received
in further future. In other words, TVM principle says that the value of given
sum of money to be received on a particular date is more than same sum of money
to be received on a later date.
While calculating time value the following points are taken into
consideration:
Present Value: When a
future payment or series of payments are discounted at the given rate of
interest up to the present date to reflect the time value of money, the
resulting value is called present value.
Future Value: Future
value is amount that is obtained by enhancing the value of a present payment or
a series of payments at the given rate of interest to reflect the time value of
money.
Interest: Interest
is charge against use of money paid by the borrower to the lender in addition
to the actual money lent.
Time Value of Money Formula
The time value of money is an important concept not just for
individuals, but also for making business decisions. Companies consider the
time value of money in making decisions about investing in new product
development, acquiring new business equipment or facilities, and in
establishing credit terms for the sale of their products or services.
A specific formula can be used for calculating the future value of
money so that it can be compared to the present value:
FV = PV x [1+ (i/n)] (nxt)
Where:
FV = the future value of money
PV = the present value
i = the interest rate or other
return that can be earned on the money
t = the number of years to take
into consideration
n = the number of compounding
periods of interest per year
Application of Time Value of Money
Principle
There are many applications of time value of money principle. For
example, we can use it to compare the worth of cash flows occurring at
different times in future, to find the present worth of a series of payments to
be received periodically in future, to find the required amount of current
investment that must be made at a given interest rate to generate a required
future cash flow, etc.
5. (a)
Discuss in detail the capital asset pricing model. 11
Ans: Capital Asset Pricing Model (CAPM)
Capital market theory is an extension of the Portfolio theory of
Markowitz. The portfolio theory explains how rational investors should build
efficient portfolio based on their risk-return preferences. Capital Market
Asset Pricing Model (CAPM) incorporates a relationship, explaining how assets
should be prices in the capital market. The capital market theory uses the
results of capital market theory to derive the relationship between the
expected returns and systematic risk of individual securities and portfolios.
Capital asset pricing model 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. It was
developed by William Sharpe along with a formula for working out the risk as
who states that with an investment come two types of risks:
1) Systematic Risk: These are risks that cannot
be diversified away such as interest rates and recessions. As the market moves
and changes occur which affect the market, each individual asset is affected to
some degree and therefore they are sensitive to change causing a high level of
risk.
2) Unsystematic (Specific): These risk can be
diversified through increasing the size of an investment portfolio as this risk
is specific to individual stocks and effectively represents no correlation
between stocks and market movements.
CAPM states that investors are compensated for
taking systematic risk however not for taking specific risk as an investor can
diversify this risk away. Systematic risk cannot be eliminated of course even
by holding all the shares in a stock market; therefore CAPM has introduced a
method of calculating that risk.
Mathematical expression of CAPM: It can be expressed mathematically
with the help of following equation:
E
(rA) = rf + βA (E (rM) - rf)
where:
E (rA) is the
expected return of the asset
rf is the risk-free
rate
E (rM) is the
expected return of the market portfolio
The general idea
of CAPM is that investors should 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 other part of the formula
represents risk and calculates the amount of compensation the investor needs
for taking on additional risk. This is done by taking an estimate of risk,
(βA), and multiplying by the MRP, (E (rM) - rf).
Graphical Presentation of CAMP
An asset is
expected to earn the risk-free rate plus a reward for bearing risk as measured
by that asset’s beta. The chart below demonstrates this predicted relationship
between beta and expected return – this line is called the Security Market
Line.
For example, a
stock with a beta of 1.5 would be expected to have an excess return of 15% in a
time period where the overall market beat the risk-free asset by 10%. The CAPM
model is used for pricing an individual security or a portfolio. For individual
securities, the security market line (SML) and its relation to expected return
and systematic risk (beta) shows how the market must price individual
securities in relation to their security risk class.
As the CAPM
predicts expected returns of assets or portfolios relative to risk and market
return, the CAPM can also be used to evaluate the performance of active fund
managers. The difference is “excess return”, which is often referred to as
alpha (α). If α is greater than zero, the portfolio lies above the Security
Market Line.
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.
Advantages of CAPM
CAPM has been a popular model for calculating
risk for over 40 years now and is therefore a proven method, some advantages
are:
a)
Ease-of-use:
CAPM is a simplistic calculation that can be easily stress-tested to derive a
range of possible outcomes to provide confidence around the required rates of
return.
b)
Systematic Risk: It considers only systematic risk,
reflecting a reality in which most investors have diversified portfolios from which
unsystematic risk has been essentially eliminated.
c)
Business
and Financial Risk Variability: When businesses investigate opportunities, if
the business mix and financing differ from the current business, then other
required return calculations, like weighted average
cost of capital (WACC)
cannot be used. However, CAPM can.
Drawbacks of CAPM
Despite the consistent use of the model over the
years there has been some criticism for a few reasons:
1)
Unrealistic
assumptions: Capital asset pricing model is based on a number of assumptions
that are far from the reality. For example it is very difficult to find a risk
free security. A short term highly liquid government security is considered as
a risk free security. It is unlikely that the government will default, but
inflation causes uncertain about the real rate of return.
2)
Based on future
expectations: The CAPM is based on expectations about the future but empirical
tests and data for practical use are exclusively based on historical returns.
3)
Risk-free Rate (Rf):
The commonly accepted rate used as the Rf is the yield on short-term
government securities. The issue with
using this input is that the yield changes daily, creating volatility.
Or
(b)
Compare and contrast between capital market line and security market line.
Ans: 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.
Security market line (SML)
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".
The SML essentially graphs the results from the capital asset
pricing model (CAPM) formula. The x-axis represents the risk (beta), and the
y-axis represents the expected return. The market risk premium is determined
from the slope of the SML. The security market line is a useful tool in
determining whether an asset being considered for a portfolio offers a
reasonable expected return for risk. Individual securities are plotted on the
SML graph. If the security's risk versus expected return is plotted above the
SML, it is undervalued because the investor can expect a greater return for the
inherent risk. A security plotted below the SML is overvalued because the
investor would be accepting less return for the amount of risk assumed.
Difference
between Capital Market Line and Security Market Line
1. The CML is a line that is used to show the rates of return,
which depends on risk-free rates of return and levels of risk for a specific
portfolio. SML, which is also called a Characteristic Line, is a graphical
representation of the market’s risk and return at a given time.
2. While standard deviation is the measure of risk in CML, Beta
coefficient determines the risk factors of the SML.
3. While the Capital Market Line graphs define efficient
portfolios, the Security Market Line graphs define both efficient and
non-efficient portfolios.
4. The CML determines the risk or return for efficient portfolios,
and the SML demonstrates the risk or return for individual stocks.
5. Where the market portfolio and risk free assets are determined
by the CML, all security factors are determined by the SML.
6. While calculating the returns, the expected return of the
portfolio for CML is shown along the Y- axis. On the contrary, for SML, the
return of the securities is shown along the Y-axis.
7. The standard deviation of the portfolio is shown along the X-axis
for CML, whereas, the Beta of security is shown along the X-axis for SML.
8. Finally, the Capital Market Line is considered to be superior
when measuring the risk factors.
6. (a)
What are the differences between Sharpe’s and Treynor’s measures of portfolio
performance? Explain with a suitable example.
11
Ans: The Sharpe Measure
In this model, performance of a fund is evaluated on the basis of
Sharpe Ratio, which is a ratio of returns generated by the fund over and above
risk free rate of return and the total risk associated with it. According to
Sharpe, it is the total risk of the fund that the investors are concerned
about. So, the model evaluates funds on the basis of reward per unit of total
risk. Symbolically, it can be written as:
Sharpe
Index (St) = (Rt - Rf)/Sd
Where, St
= Sharpe’s Index
Rt=
represents return on fund and
Rf=
is risk free rate of return.
Sd=
is the standard deviation
While a high and positive Sharpe Ratio shows a superior
risk-adjusted performance of a fund, a low and negative Sharpe Ratio is an
indication of unfavorable performance. This index gives a measure of portfolios
total risk and variability of returns in relation to the risk premium. This
method ranks all portfolios on the basis of St. Larger the value of St, the better
the performance of the portfolio.
The following figure gives a graphic representation of Sharpe’s
index. Sd measure the slope of the line emanating from the risk less rate
outward to the portfolio in question.
Example
|
Portfolio |
Average
return |
S.D. |
Risk
Free Rate |
|
A |
15% |
3% |
9% |
|
B |
20% |
8% |
9% |
SA = (15 – 9)/3 = 2
SB = (20 – 9)/8 = 1.375
Thus, portfolio A is ranked higher because its index i.e. 2.0 is
higher as compare to B’s index i.e. 1.375. This is despite the fact that B has
a higher return (20% >15%)
The
Treynor Measure
Jack L. Treynor based his model on the concept of characteristic
line. This line is the least square regression line relating the return to the
risk and beta is the slope of the line. The slope of the line measures
volatility. A steep slope means that the actual rate of return for the
portfolio is highly sensitive to market performance whereas a gentle slope
indicates that the actual rate of return for the portfolio is less sensitive to
market fluctuations.
The Treynor index, also commonly known as the reward-to-volatility
ratio, is a measure that quantifies return per unit of risk. This Index is a
ratio of return generated by the fund over and above risk free rate of return,
during a given period and systematic risk associated with it (beta). The portfolio beta is a measure of
portfolio volatility, which is used as a proxy for overall risk – specifically
risk that cannot be diversified. A beta of one indicates volatility on par with
the broader market, usually an equity index. A beta of 0.5 means half the
volatility of the market. Portfolios with twice the volatility of the market
would be given a beta of 2. Symbolically, Treynor’s ratio can be
represented as:
Treynor's
Index (Tt) = (Rt
– Rf)/Bt
Whereas,
Tt = Treynor’
measure of portfolio
Rt = Return of
the portfolio
Rf = Risk free
rate of return
Bt = Beta
coefficient or volatility of the portfolio
All risk-averse investors would like to maximize this value. While
a high and positive Treynor's Index shows a superior risk-adjusted performance
of a fund, a low and negative Treynor's Index is an indication of unfavorable
performance. Treynor ratios
can be used in both an ex-ante and ex-post sense. The ex-ante form of the ratio
uses expected values
for all variables, while the ex-post variation uses realized values.
Graphically Treynor’s measure is depicted as:
Example
|
Portfolio |
Return |
Volatility |
Risk
free Rate |
|
A |
20% |
5% |
8% |
|
B |
24% |
8% |
8% |
Treynor’s index has ranked portfolio A as the better performer
because value is higher (2.4 > 2.0) despite the fact that portfolio B has a
higher return (24% > 20%). It is due to the difference in volatility of two
portfolios.
Difference
between Sharpe’s and Treynor’s
Comparison of Sharpe’s and Treynor’s
measures of portfolio performance
|
Basis |
Sharpe |
Treynor |
|
Risk |
Sharpe used standard deviation as the
risk measure to capture the overall risk of the portfolio. |
Treynor used
beta as the risk measure to capture
the volatility of the portfolio relative to the market. |
|
Applicability |
Sharpe ratio is applicable to all portfolios. |
Treynor is applicable to well-diversified portfolios. |
|
Performance
measurement |
Sharpe is a more forward-looking performance measure. |
Treynor is used to measure historical performance. |
|
Risk |
According
to Sharpe, investor is concerned about the total risk. |
According
to Treynor, investor is concerned about the systematic risk. |
|
Formula |
Sharpe
Index (St) = (Rt - Rf)/Sd |
Treynor's
Index (Tt) = (Rt
– Rf)/Bt |
Or
(b) Determine the Treynor’s and Jensen’s measures of portfolio
performance from the given information:
Average rate of return
on market portfolio 18%
Average rate of return
on this portfolio 19%
Average risk-free rate
of return 12%
Standard deviation of
this portfolio 14%
Beta of portfolio under
consideration 0.95
7.
(a) Write a note on the contract specifications in case of options. Discuss the
process of trading of options. 5+6=11
Or
(b) Differentiate between an option and a future. What are the essential specifications of a future contract? Explain. 5+6=11
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