Ques 1:

From the following information, calculate the volatility of the portfolio and comment on the
relationship among the stocks return.
Day Stock A Stock B Stock C
1 0.4 2.2 0.6
2 1.1 1.3 0.5
3 0.9 1.2 1.4
4 1.7 1.9 1.6
Answer:

Introduction:

Volatility is a statistical measure of the dispersion of returns for a given security or market
index. In most cases, the higher the volatility, the riskier the security. Volatility is often
measured as either the standard deviation or variance between returns from that same
security or market index.

In the securities markets, volatility is often associated with big swings in either direction.
For example, when the stock market rises and falls more than one percent over a sustained
period of time, it is called a "volatile" market. An asset's volatility is a key factor when
pricing options contracts.

One way to measure an asset's variation is to quantify the daily returns (percent move on a
daily basis) of the asset. Historical volatility is based on historical prices and represents the
degree of variability in the returns of an asset. This number is without a unit and is
expressed as a percentage.

While variance captures the dispersion of returns around the mean of an asset in general,
volatility is a measure of that variance bounded by a specific period of time. Thus, we can
report daily volatility, weekly, monthly, or annualized volatility. It is, therefore, useful to
think of volatility as the annualized standard deviation.

Volatility is often calculated using variance and standard deviation. The standard deviation
is the square root of the variance.

Discussion:

Stock A=

1. Find the mean of the data set. This means adding each value and then dividing it by the
number of values.

=> 0.4+1.1+0.9+1.7 = 4.1

=> 4.1/4= 1.025

2. Calculate the difference between each data value and the mean. This is often called
deviation. This continues all the way down to the first data value of 0.4. Negative numbers
are allowed.

=> 1.025- 0.4 = 0.625

=> 1.025- 1.1 = -0.075

=> 1.025- 0.9 = 0.125

=> 1.025- 1.7 = -0.675

3. Square the deviations. This will eliminate negative values.

=> 0.625 = 0.390625

=> -0.075 = 0.005625

=> 0.125 = 0.015625

=> -0.675 = 0.455625

Total = 0.8675

4. Add the squared deviations together. In our example, this equals 0.8675

5. Divide the sum of the squared deviations (0.8675) by the number of data values.

= 0.8675/4 = 0.216875

In this case, the resulting variance is 0.216875.

6. The square root is taken to get the standard deviation. This equals 0.46569. This is a
measure of risk and shows how values are spread out around the average price. It gives
traders an idea of how far the price may deviate from the average.

Standard Deviation = 0.46569

Similarly, we have to follow above steps for stock B and stock C

Stock B

1. Find the mean of the data set. This means adding each value and then dividing it by
the number of values

= 2.2+1.3+1.2+1.9= 6.6

 6.6/4 = 1.65
2. Calculate the difference between each data value and the mean. This is often called
deviation. This continues all the way down to the first data value of 0.4. Negative numbers
are allowed.

 1.65 - 2.2 = -0.55

 1.65 - 1.3 = 0.35
 1.65 - 1.2 = 0.45
 1.65 - 1.9 = - 0.25

3. Square the deviations. This will eliminate negative values.

 -0.55 = 0.3025
 0.35 = 0.1225
 0.45 = 0.2025
 -0.25 =0.0625

Total = 0.69

4. Add the squared deviations together. In our example, this equals 0.69

5. Divide the sum of the squared deviations (0.69) by the number of data values.

 0.69/4 = 0.1725

In this case, the resulting variance is 0.1725

6. The square root is taken to get the standard deviation. This equals 0.41533. This is a
measure of risk and shows how values are spread out around the average price. It gives
traders an idea of how far the price may deviate from the average.

 Standard Deviation = 0.41533

Stock C

1. Find the mean of the data set. This means adding each value and then dividing it by the
number of values

=> 0.6+0.5+1.4+1.6 = 4.1

=> 4.1/4 = 1.025

2. Calculate the difference between each data value and the mean. This is often called
deviation. This continues all the way down to the first data value of 0.4. Negative numbers
are allowed.

 1.025 – 0.6 = 0.425

 1.025 – 0.5 = 0.525
 1.025 – 1.4 = -0.375
  1.025 – 1.6 = -0.575

3. Square the deviations. This will eliminate negative values.

 0.425 = 0.18062
 0.525 = 0.27562
 -0.375 = 0.14062
 -0.575 = 0.33062

4. Add the squared deviations together. In our example, this equals 0.92748

Total = 0.92748

5. Divide the sum of the squared deviations (0.92748) by the number of data values.

 0.92748/4 = 0.23187

In this case, the resulting variance is 0.23187

6. The square root is taken to get the standard deviation. This equals 0.48152. This is a
measure of risk and shows how values are spread out around the average price. It gives
traders an idea of how far the price may deviate from the average.

Standard Deviation = 0.48152

Conclusion:

This is a measure of risk and shows how values are spread out around the average price. It
gives traders an idea of how far the price may deviate from the average.

There is evidence for a double relation between volatility and returns in equity markets.
Longer-term fluctuations of volatility mostly reflect risk premiums and hence establish a
positive relation to returns. Short-term swings in volatility often indicate news effects and
shocks to leverage, causing to a negative volatility-return relation.

The two relations between volatility and returns

“Volatility of a stock may incur a risk premium, leading to a positive correlation between
volatility and returns. On the other hand the leverage effect [or news effect], whereby
negative returns increase volatility, acts in the opposite direction. “

“The leverage effect in finance suggests that volatility rises when the asset price falls. The
rise in volatility following a fall in the asset price need not necessarily be due to leverage as
such. For example the label ‘news impact curve’ is often used instead of leverage, reflecting
the idea that a sharp fall in asset price may induce more uncertainty and hence higher
variability.”

“Returns may have an asymmetric effect on volatility [with negative returns pushing
volatility up but positive returns not immediately pushing it down]. For example,
considerations of leverage suggests that negative returns are associated with increased
volatility. Indeed the term leverage is often loosely used to indicate any kind of asymmetry in
the response of volatility to returns, it may be that an asymmetric response is confined to the
short-run volatility component.”

Ques 2. You are a financial advisor at XYZ Stock Broking firm. Calculate the return as per
CAPM for following company’s stock, identify whether the stocks are undervalued,
overvalued or correctly priced and advise accordingly. Returns of T- Bill is 7%.
Stock Expected Beta
Return
Tata 21% 1.7
Adani Power 16% 1.4
Ranbaxy 23% 1.1
PNB 19% 1.2
Sensex 18%
Answer:

Introduction:

The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk
and expected return for assets, particularly stocks. CAPM is widely used throughout finance
for pricing risky securities and generating expected returns for assets given the risk of those
assets and cost of capital.

The formula for calculating the expected return of an asset given its risk is as follows:

ERi=Rf+βi(ERm−Rf)

where: ERi=expected return of investment

Rf=risk-free rate

βi=beta of the investment

(ERm−Rf)=market risk premium

Investors expect to be compensated for risk and the time value of money. The risk-free
rate in the CAPM formula accounts for the time value of money. The other components of
the CAPM formula account for the investor taking on additional risk.

The beta of a potential investment is a measure of how much risk the investment will add to
a portfolio that looks like the market. If a stock is riskier than the market, it will have a beta
greater than one. If a stock has a beta of less than one, the formula assumes it will reduce the
risk of a portfolio.

A stock’s beta is then multiplied by the market risk premium, which is the return expected
from the market above the risk-free rate. The risk-free rate is then added to the product of
the stock’s beta and the market risk premium. The result should give an investor the required
return or discount rate they can use to find the value of an asset.

The goal of the CAPM formula is to evaluate whether a stock is fairly valued when its risk
and the time value of money are compared to its expected return.

The expected return of the CAPM formula is used to discount the expected dividends and
capital appreciation of the stock over the expected holding period. If the discounted value of
those future cash flows is equal to $100 then the CAPM formula indicates the stock is fairly
valued relative to risk.

Discussion: Using the CAPM to build a portfolio is supposed to help an investor manage
their risk. If an investor were able to use the CAPM to perfectly optimize a portfolio’s return
relative to risk, it would exist on a curve called the efficient frontier.

ERi=Rf+βi(ERm−Rf)
For Tata Stock Risk free return is -13%

 21% = Rf + 1.7(7%- Rf)

 21% - 11.9% = Rf – 1.7 Rf
 9.1%= -0.7 Rf
 -13% = Rf

For Adani Power Stock Risk free return is -15.5%

 16% = Rf + 1.4(7%- Rf)

 16% - 9.8% = Rf – 1.4 Rf
 6.2%= -0.4 Rf
 -15.5% = Rf

For Ranbaxy Stock Risk free return is -1.53%

 23% = Rf+ 1.1(7%- Rf)

 23% - 7.7% = Rf – 1.1 Rf
 15.3%= -0.1 Rf
 -1.53% = Rf

For PNB Stock Risk free return is -0.53%

 19% = Rf+ 1.2(7%- Rf)

 19% - 8.4% = Rf – 1.2 Rf
 10.6%= -0.2 Rf
 -0.53% = Rf

Modern Portfolio Theory suggests that starting with the risk-free rate, the expected return of
a portfolio increases as the risk increases. Any portfolio that fits on the Capital Market Line
(CML) is better than any possible portfolio to the right of that line, but at some point, a
theoretical portfolio can be constructed on the CML with the best return for the amount of
risk being taken.

The CML and efficient frontier may be difficult to define, but it illustrates an important
concept for investors: there is a trade-off between increased return and increased risk.
Because it isn’t possible to perfectly build a portfolio that fits on the CML, it is more
common for investors to take on too much risk as they seek additional return.

The efficient frontier assumes the same things as the CAPM and can only be calculated in
theory. If a portfolio existed on the efficient frontier it would be providing the maximal
return for its level of risk. However, it is impossible to know whether a portfolio exists on
the efficient frontier or not because future returns cannot be predicted.

This trade-off between risk and return applies to the CAPM and the efficient frontier graph
can be rearranged to illustrate the trade-off for individual assets. In the following chart, you
can see that the CML is now called the Security Market Line (SML).
The CAPM and SML make a connection between a stock’s beta and its expected risk. A
higher beta means more risk but a portfolio of high beta stocks could exist somewhere on the
CML where the trade-off is acceptable, if not the theoretical ideal.

The value of these two models is diminished by assumptions about beta and market
participants that aren’t true in the real markets. For example, beta does not account for the
relative riskiness of a stock that is more volatile than the market with a high frequency of
downside shocks compared to another stock with an equally high beta that does not
experience the same kind of price movements to the downside.

Conclusion:

The CAPM uses the principles of Modern Portfolio Theory to determine if a security is
fairly valued. It relies on assumptions about investor behaviours, risk and return
distributions, and market fundamentals that don’t match reality. However, the underlying
concepts of CAPM and the associated efficient frontier can help investors understand the
relationship between expected risk and reward as they make better decisions about adding
securities to a portfolio.

Ques 3. Sunaina has qualified her Investment Banking certification and has applied for a job
with an Investment bank. As a part of preliminary round of interview, she is supposed to
answer the following questions
a. Factors that impacts the investment decisions of a person.

b. Difference between the two main classes of financial instruments that an investor uses in
their portfolios.

Answer:

Introduction:

Investment has always been a pretty intriguing aspect. It gives investors the opportunity to
generate wealth and expand their horizon in terms of finance. No doubt we all have been
fascinated with the allure of investing since the very beginning. What started as a mere
investment into traditional means like gold, real estate and more has grown with time to add
different verticals like equity, debt, commodities and more.

Whether it’s a seasoned investor or someone who is staking first claims into the investment
scene, there are major factors that influence our investment choices.

Discussion:

Major Factors that Influence our Investment Choices

• Investment Goals: First things first, it always starts with setting up goals. We
need to be aware of our requirements before starting our investment journey. It is
what ends up influencing our investment objectives. Whether you’re planning to
invest in your retirement plan or your dream home or funding your child’s
 education or to simply to meet a future expense, you should be clear of your goals.
You can set your goals as short-term ones or mid-term or long-term depending
upon the length and requirement. This way you can streamline your investment
choices accordingly to your goals. We’ve seen people venture into investment
schemes based on their goals. For someone who has a short term goal goes for
bank fixed deposits, mutual funds and more while for those seeking midterm to
long term go for equity investment. Here let’s take an example, if you want to
reach around Rs 10 lacs by the age of 35, you should invest the money wisely in
suitable investment options so that you can attain the goal.
• Risk Tolerance Level: Understanding the risk tolerance level that you can
entertain helps you to handle the risk and anxiety that comes with the investment.
Risk tolerance is often affected by our perception of risk. Some of the people may
be willing to settle for a lower return if there’s low-risk in it. While some may look
to leverage high-risk in order to yield high returns. Understanding your level of
risk tolerance is a major marker in making investment choices. Someone who is
able to handle high risk can go for volatile options like equity and more while
someone who prefers to have a low-risk profile can opt for fixed deposit, gold, real
estate among few. Although, historically equity market has been a highly
rewarding platform and has seen plenty of gains over the period and is much
preferred of the lot.
• Income Level: Investment requires you to put in your money in order to get
returns and seek growth in your wealth. Our income levels define the amount of
money we can invest in the market. It may also have an impact on our risk
tolerance level. Investors with a large pool of income are more inclined towards
making riskier decisions and make large investments than someone with a lower
spectrum of income. Having a larger income stream can certainly open avenues to
different investment patterns and choices.
• Taxation Liability: Taxation liability often impacts our income and reduces our
investable income. And with lesser investible income, you will obviously have to
settle for a lesser return. It’s a prominent factor when it comes to influencing our
investment decisions. But it’s not all dull and glooms for an investor as there are
various investment schemes that help to reduce the tax liability. The options like
ELSS and other hosts of Sec 80CC related investments have become a preferred
choice for people who want to invest and avail tax benefits. These give you the
benefit of increasing your wealth all the while saving on taxes.
• Emotional Check: Investment is an area where emotion does tend to influence our
decisions a lot. It’s not a surprise that the market is often driven by the emotional
pull and allure of people going by the rumour rather than making logical decisions.
To be fair, investment requires one to keep their emotions in check and don’t
indulge in rash decision making. For example, the stock market often tends to go
through different wavelengths and is subject to bearish or bullish trends. Most of
the people are stuck at thoughts of whether to hold or encash on the stocks. This is
where opting for patients and maintaining your stance in line with your goals will
help you. Similarly, there are still fractions of people in India who invest in gold
and real estate primarily due to emotional allure.
• Need for Liquidity: One cannot discount the fact that there may arise some
unforeseeable situations where you will need an influx of cash on an urgent basis.
We all have heard of the phenomenon that we should keep an emergency fund
aside for this matter. But in times of need, where emergency funds do not suffice
 you may have to dip hands into your investment and liquidate them. Liquidity
refers to the degree to which you can convert the asset or security quickly into
cash. The ability to liquidate your assets is one of the major influencers for anyone
making investment choices. There are plenty of assets that have high liquidity like
stocks, fixed deposits, liquid funds and more where people are investing into. It’s
not that you should go for high liquidity investment only but the ability to quickly
sell them off in times of need is a real deal-breaker.
Conclusion: Investment is often guided or influenced by plenty of other factors apart from
the aforementioned one. Aspects like family history, personal profile, financial obligations,
and others also tend to affect your investment choices. These aforementioned factors do tend
to influence the choices, but it’s still in the hands of the investor to build a solid investment
portfolio based on the need and profile of the investor. It’s advised to create a strategy that
helps you to structure and balance your portfolio while also giving you the chance for
optimum return.

Answer 3(b)

Introduction:

Financial instruments are assets that can be traded, or they can also be seen as packages of
capital that may be traded. Most types of financial instruments provide efficient flow and
transfer of capital all throughout the world's investors. These assets can be cash, a
contractual right to deliver or receive cash or another type of financial instrument, or
evidence of one's ownership of an entity.

Understanding Financial Instruments

Financial instruments can be real or virtual documents representing a legal agreement
involving any kind of monetary value. Equity-based financial instruments represent
ownership of an asset. Debt-based financial instruments represent a loan made by an
investor to the owner of the asset.

Foreign exchange instruments comprise a third, unique type of financial instrument.

Different subcategories of each instrument type exist, such as preferred share equity and
common share equity.

International Accounting Standards (IAS) defines financial instruments as "any contract that
gives rise to a financial asset of one entity and a financial liability or equity instrument of
another entity."1

Discussion:

Types of Financial Instruments

Financial instruments may be divided into two types: cash instruments and derivative
instruments.
Cash Instruments

• The values of cash instruments are directly influenced and determined by the
markets. These can be securities that are easily transferable.
• Cash instruments may also be deposits and loans agreed upon by borrowers
and lenders.

Derivative Instruments

• The value and characteristics of derivative instruments are based on the vehicle’s
underlying components, such as assets, interest rates, or indices.
• An equity options contract, for example, is a derivative because it derives its value
from the underlying stock. The option gives the right, but not the obligation, to buy
or sell the stock at a specified price and by a certain date. As the price of the stock
rises and falls, so too does the value of the option although not necessarily by the
same percentage.
• There can be over-the-counter (OTC) derivatives or exchange-traded derivatives.
OTC is a market or process whereby securities–that are not listed on formal
exchanges–are priced and traded.

Types of Asset Classes of Financial Instruments

Financial instruments may also be divided according to an asset class, which depends on
whether they are debt-based or equity-based.

Debt-Based Financial Instruments

Short-term debt-based financial instruments last for one year or less. Securities of this kind
come in the form of T-bills and commercial paper. Cash of this kind can be deposits and
certificates of deposit (CDs).

Exchange-traded derivatives under short-term, debt-based financial instruments can be

short-term interest rate futures. OTC derivatives are forward rate agreements.

Long-term debt-based financial instruments last for more than a year. Under securities, these
are bonds. Cash equivalents are loans. Exchange-traded derivatives are bond futures and
options on bond futures. OTC derivatives are interest rate swaps, interest rate caps and
floors, interest rate options, and exotic derivatives.

Equity-Based Financial Instruments

Securities under equity-based financial instruments are stocks. Exchange-traded derivatives
in this category include stock options and equity futures. The OTC derivatives are stock
options and exotic derivatives.

Conclusion:

There are no securities under foreign exchange. Cash equivalents come in spot foreign
exchange, which is the current prevailing rate. Exchange-traded derivatives under foreign
exchange are currency futures. OTC derivatives come in foreign exchange options, outright
forwards, and foreign exchange swaps.