Portfolio Management

Chapter 4
Portfolio Management
Q7 Ex. Book No. Pg. No.

Consider the following information on two stocks, X and Y.

Year 2016 2017

Return on X (%) 10 16
Return on Y (%) 12 18

You are required to calculate:

(i) The expected return on a portfolio containing X and Y in the proportion of 40% and 60%
respectively.
(ii) The Standard Deviation of return from each of the two stocks.
(iii) The Covariance of returns from the two stocks.
(iv) The Correlation coefficient between the returns of the two stocks.
(v) The risk of a portfolio containing X and Y in the proportion of 40% and 60%.

Modern Portfolio Theory Several Calculation

Q 17 Ex. Book No. Pg. No.

Pearl Ltd. expects that considering the current market prices, the equity share holders should get a re-
turn of at least 15.50% while the current return on the market is 12%. RBI has closed the latest auction
for ` 2500 crores of 182 day bills for the lowest bid of 4.3% although there were bidders at a higher
rate of 4.6% also for lots of less than ` 10 crores. What is Pearl Ltd’s Beta?

Capital Market Theory Computing Rf and Beta

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Answer
Determining Risk free rate: Two risk free rates are given. The aggressive approach would be to con-
sider 4.6% while the conservative approach would be to take 4.3%. If we take the moderate value then
the simple average of the two i.e. 4.45% would be considered
Application of CAPM
Rj = Rf + β (Rm – Rf )
15.50% = 4.45% + β (12% - 4.45%)

15.50% − 4.45% 11.05

β= =
12% − 4.45% 7.55

= 1.464

Q 18 Ex. Book No. Pg. No.

The following information is available in respect of Security A:

Equilibrium Return 12%

Market Return 12%
6% Treasury Bond trading at ` 120
Co-variance of Market Return and Security Return 196%
Coefficient of Correlation 0.80

You are required to determine the Standard Deviation of:

(i) Market Return and
(ii) Security Return

Capital Market Theory Computation of SD of market

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Q 24 Ex. Book No. Pg. No.

The expected returns and Beta of three stocks are given below

Stock A B C

Expected Return (%) 18 11 15

Beta Factor 1.7 0.6 1.2

If the risk free rate is 9% and the expected rate of return on the market portfolio is 14% which of the
above stocks are over, under or correctly valued in the market? What shall be the strategy?

Capital Market Theory Under or Over or Correctly

valued

Answer
Required Rate of Return is given by
Rj = Rf + β (Rm-Rf )
For Stock A, Rj = 9 + 1.7 (14 - 9) = 17.50%
Stock B, Rj = 9 + 0.6 (14-9) = 12.00%
Stock C, Rj = 9 + 1.2 (14-9) = 15.00%

Required Return % Expected Return % Valuation Decision

17.50% 18.00% Under Valued Buy
12.00% 11.00% Over Valued Sell
15.00% 15.00% Correctly Valued Hold

Q 28 Ex. Book No. Pg. No.

XYZ Ltd. has substantial cash flow and until the surplus funds are utilised to meet the future capital
expenditure, likely to happen after several months, are invested in a portfolio of short term equity
investments, details for which are given below:

Investment No. of shares Beta Market price per share ` Expected dividend yield
I 60,000 1.16 4.29 19.50%
II 80,000 2.28 2.92 24.00%
III 1,00,000 0.90 2.17 17.50%
IV 1,25,000 1.50 3.14 26.00%

The current market return is 19% and the risk free rate is 11%.

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Required to:
(i) Calculate the risk of XYZ’s short-term investment portfolio relative to that of the market;
(ii) Whether XYZ should change the composition of its portfolio.

Capital Market Theory Implicit beta

Answer
(i) Computation of Beta of Portfolio

Invest- No. of Market Market Dividend Composi-

Dividend β Weighted β
ment shares Price Value Yield tion
I. 60,000 4.29 2,57,400 19.50% 50,193 0.2339 1.16 0.27
II. 80,000 2.92 2,33,600 24.00% 56,064 0.2123 2.28 0.48
III. 1,00,000 2.17 2,17,000 17.50% 37,975 0.1972 0.90 0.18
IV. 1,25,000 3.14 3,92,500 26.00% 1,02,050 0.3566 1.50 0.53
11,00,500 2,46,282 1.0000 1.46
2, 46 , 282
Return of the Portfolio = 0.2238
11, 00 , 500
Beta of Port Folio 1.46
Market Risk implicit
0.2238 = 0.11 + β× (0.19 – 0.11)
Or, 0.08 β + 0.11 = 0.2238
0.2238 − 0.11
β= = 1.42
0.08
Market β implicit is 1.42 while the port folio β is 1.46. Thus the portfolio is marginally risky com-
pared to the market.
(ii) The decision regarding change of composition may be taken by comparing the dividend yield
(given) and the expected return as per CAPM as follows:
Expected return Rs as per CAPM is:
Rs = IRF + (RM – I RF) β
For investment I Rs = IRF + (RM – IRF) β
= .11 + (.19 - .11) 1.16
= 20.28%
For investment II, Rs = .11 + (.19 - .11) 2.28 = 29.24%

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For investment III, Rs = .11 + (.19 - .11) .90

= 18.20%
For investment IV, Rs = .11 + (.19 - .11) 1.50
= 23%
Comparison of dividend yield with the expected return Rs shows that the dividend yields of in-
vestment I, II and III are less than the corresponding Rs,. So, these investments are overpriced and
should be sold by the investor. However, in case of investment IV, the dividend yield is more than
the corresponding Rs, so, XYZ Ltd. should increase its proportion.

Q 32 Ex. Book No. Pg. No.

Following are the details of a portfolio consisting of three shares:

Share Portfolio weight Beta Expected return in % Total variance

A 0.20 0.40 14 0.015
B 0.50 0.50 15 0.025
C 0.30 1.10 21 0.100

Standard Deviation of Market Portfolio Returns = 10%

You are given the following additional data:
Covariance (A, B) = 0.030
Covariance (A, C) = 0.020
Covariance (B, C) = 0.040
Calculate the following:
(i) The Portfolio Beta
(ii) Residual variance of each of the three shares
(iii) Portfolio variance using Sharpe Index Model
(iv) Portfolio variance (on the basis of modern portfolio theory given by Markowitz)

Capital Market Theory CMT and MPT

Answer
(i) Portfolio Beta
0.20 x 0.40 + 0.50 x 0.50 + 0.30 x 1.10 = 0.66

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(ii) Residual Variance

To determine Residual Variance first of all we shall compute the Systematic Risk as follows:

β2A × σM2 = ( 0.40 ) ( 0.01) = 0.0016

2

β2A × σM2 = ( 0.50 ) ( 0.01) = 0.0025

2

β2C × σM2 = (1.10 ) ( 0.01) = 0.0121

2

Residual Variance
A 0.015 – 0.0016 = 0.0134
B 0.025 – 0.0025 = 0.0225
C 0.100 – 0.0121 = 0.0879
(iii) Portfolio variance using Sharpe Index Model
Systematic Variance of Portfolio = (0.10)2 x (0.66)2 = 0.004356
Unsystematic Variance of Portfolio = 0.0134 x (0.20)2 + 0.0225 x (0.50)2 + 0.0879 x (0.30)2 =
0.014072
Total Variance = 0.004356 + 0.014072 = 0.018428
(iii) Portfolio variance on the basis of Markowitz Theory

= (wA x wAx σ2A ) + (wA x wB x CovAB) + (wA x wC x CovAC) + (wB x wA x CovAB) + (wB x wB x σB ) + (wB x
2

wC x CovBC) + (wC x wA x CovCA) + (wC x wB x CovCB) + (wC x wCx σ2C )

= (0.20 x 0.20 x 0.015) + (0.20 x 0.50 x 0.030) + (0.20 x 0.30 x 0.020) + (0.20 x 0.50 x 0.030) + (0.50
x 0.50 x 0.025) + (0.50 x 0.30 x 0.040) + (0.30 x 0.20 x 0.020) + (0.30 x 0.50 x 0.040) + (0.30 x 0.30
x 0.10)
= 0.0006 + 0.0030 + 0.0012 + 0.0030 + 0.00625 + 0.0060 + 0.0012 + 0.0060 + 0.0090
= 0.0363

Q 34 Ex. Book No. Pg. No.

Mr. Abhishek is interested in investing ` 2,00,000 for which he is considering following three alterna-
tives:
(i) Invest ` 2,00,000 in Mutual Fund X (MFX)
(ii) Invest ` 2,00,000 in Mutual Fund Y (MFY)
(iii) Invest ` 1,20,000 in Mutual Fund X (MFX) and ` 80,000 in Mutual Fund Y (MFY)
Average annual return earned by MFX and MFY is 15% and 14% respectively. Risk free rate of return is
10% and market rate of return is 12%.
Covariance of returns of MFX, MFY and market portfolio Mix are as follow:

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MFX MFY Mix

MFX 4.800 4.300 3.370
MFY 4.300 4.250 2.800
Mix 3.370 2.800 3.100

You are required to calculate:

(i) Variance of return from MFX, MFY and market return,
(ii) Portfolio return, beta, portfolio variance and portfolio standard deviation,
(ill) Expected return, systematic risk and unsystematic risk; and
(iv) Sharpe ratio, Treynor ratio and Alpha of MFX, MFY and Portfolio Mix

Capital Market Theory CMT and MPT

Q 40 Ex. Book No. Pg. No.

Mr. Tamarind intends to invest in equity shares of a company the value of which depends upon various
parameters as mentioned below:

Factors Beta Expected Value in % Actual Value in %

GNP 1.2 7.7 7.7
Inflation 1.75 5.5 7
Interest Rate 1.3 7.75 9
Stock Market Index 1.7 10 12
Industrial Production 1 7 7.5

If the risk free rate of interest be 9.25%, how much is the return of the share under Arbitrage pricing
theory?

Arbitrage Pricing Theory

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Q 41 Ex. Book No. Pg. No.

Mr. X owns a portfolio with the following characteristics:

Security A Security B Risk Free security

Factor 1 sensitivity 0.80 1.50 0
Factor 2 sensitivity 0.60 1.20 0
Expected Return 15% 20% 10%

It is assumed that security returns are generated by a two factor model.

(i) If Mr. X has ` 1,00,000 to invest and sells short ` 50,000 of security B and purchases ` 1,50,000 of
security A what is the sensitivity of Mr. X’s portfolio to the two factors?
(ii) If Mr. X borrows ` 1,00,000 at the risk free rate and invests the amount he borrows along with the
original amount of ` 1,00,000 in security A and B in the same proportion as described in part (i),
what is the sensitivity of the portfolio to the two factors?
(iii) What is the expected return premium of factor 2?

Arbitrage Pricing Theory

HWQ 1 Ex. Book No. Pg. No.

A stock costing ` 120 pays no dividends. The possible prices that the stock might sell for at the end of
the year with the respective probabilities are:

Price Probability
115 0.1
120 0.1
125 0.2
130 0.3
135 0.2
140 0.1
Required:
(i) Calculate the expected return.
(ii) Calculate the Standard deviation of returns.

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Modern Portfolio Theory

HWQ 2 Ex. Book No. Pg. No.

Mr. A is interested to invest ` 1,00,000 in the securities market. He selected two securities B and D for
this purpose. The risk return profile of these securities are as follows :

Security Risk (σ ) Expected Return (ER)

B 10% 12%
D 18% 20%

Co-efficient of correlation between B and D is 0.15.

You are required to calculate the portfolio return of the following portfolios of B and D to be consid-
ered by A for his investment.
(i) 100 percent investment in B only;
(ii) 50 percent of the fund in B and the rest 50 percent in D;
(iii) 75 percent of the fund in B and the rest 25 percent in D; and
(iv) 100 percent investment in D only.
Also indicate that which portfolio is best for him from risk as well as return point of view?

Modern Portfolio Theory

HWQ 6 Ex. Book No. Pg. No.

The Stock Research Division of Bharati Investment Services Ltd. has developed ex-ante probability
distribution for the likely economic scenarios over the next one year and estimates the corresponding
one period rates of return on Stock A, B and Market Index as follows:

Economic scenarios Probability One period rate of return %

Stock A Stock B Market
Recession 0.15 -15 -3 -10
Low growth 0.25 10 7 13
Medium growth 0.45 25 15 18
High growth 0.15 40 25 32

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The expected risk free real rate of return and the premium for inflation are 3.0% and 6.5% p.a. respec-
tively.
As a financial analyst in the Research Division you are required to calculate the following for stock A
and stock B:
(i) Expected return
(ii) Covariance of returns with the market returns
(iii) Beta

Capital Market Theory Inflation Premium

HWQ 9 Ex. Book No. Pg. No.

Treasury Bills give a return of 5%. Market Return is 13%
(i) What is the market risk premium
(ii) Compute the β Value and required returns for the following combination of investments.

Treasury Bill 100 70 30 0

Market 0 30 70 100

Capital Market Theory Portfolio Beta

Answer
Risk Premium Rm – Rf = 13% - 5% = 8%
β is the weighted average investing in portfolio consisting of market β = 1 and treasury bills (β = 0)
Portfolio Treasury Bills: Market β Rj = Rf + β × (Rm – Rf)
1 100:0 0 5% + 0(13%-5%)=5%
2 70:30 0.7(0)+0.3(1)=0.3 5%+0.3(13%-5%)=7.40%
3 30:70 0.3(0)+0.7(1)=0.7 5%+0.7(13%-5%)=10.60%
4 0:100 1 5%+1.0(13%-5%)=13%

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HWQ 10 Ex. Book No. Pg. No.

Information about return on an investment is as follows:

(a) Risk free rate 10% (b) Market Return is 15% (c) Beta is 1.2
(i) What would be the return from this investment?
(ii) If the projected return is 18%, is the investment rightly valued?
(iii) What is your strategy?

Capital Market Theory Under or Over Valuation

Answer
Required rate of Return as per CAPM is given by
Rj = Rf + β (Rm-Rf )
= 10 +1.2 (15-10) = 16%
If projected return is 18%, the stock is undervalued as CAPM < Expected Return .The Decision should
be BUY.

HWQ 11 Ex. Book No. Pg. No.

Mr. FedUp wants to invest an amount of ` 520 lakhs and had approached his Portfolio Manager. The
Portfolio Manager had advised Mr. FedUp to invest in the following manner:
Security Moderate Better Good Very Good Best
Amount (in ` Lakhs) 60 80 100 120 160
Beta 0.5 1.00 0.80 1.20 1.50
You are required to advise Mr. FedUp in regard to the following, using Capital Asset Pricing Method-
ology:
(i) Expected return on the portfolio, if the Government Securities are at 8% and the NIFTY is yielding
10%.
(ii) Advisability of replacing Security ‘Better’ with NIFTY.

Capital Market Theory Portfolio Return

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HWQ 14 Ex. Book No. Pg. No.

A Portfolio Manager has the following four stocks in his portfolio:

Security No. of shares Market price (`) per share β = Beta
ADU 12,000 40 0.9
DVU 6,000 20 1.0
NDU 10,000 25 1.5
SVU 2,000 225 1.2
Compute the following:
(i) Portfolio Beta (β)
(ii) If the Portfolio Manager seeks to reduce the portfolio Beta to 0.8, how much risk-free investment
should he bring in? Consider that he disposes the riskier securities first and replaces them with
risk free investment. Present the revised portfolio.

Portfolio Beta Management

Answer
(i)
Security No. of Shares MPS MV Beta Product
ADU 12,000 40 4,80,000 0.9 4,32,000
DVU 6,000 20 1,20,000 1.0 1,20,000
NDU 10,000 25 2,50,000 1.5 3,75,000
SVU 2,000 225 4,50,000 1.2 5,40,000
13,00,000 14,67,000
14 , 67, 000
β= = 1.1285 = 1.13
13, 00 , 000
(ii) Reduce β to 0.8
Beta can be reduced replacing High beta stocks in the portfolio with risk free investment which
carry a Beta of Zero.
∴ Required Value = 0.8 × 13,00,000 = 10,40,000
Difference in value = ` 14,67,000 – 10,40,000 = 4,27,000
` 4,27,000 should be eliminated from product column (Value).
NDU has highest β and to be replaced ` 3,75,000.

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Remaining value ` 52,000

Next highest beta is of SVU
Market value of ` 52,000 (Product) 52,000/1.2 = ` 43,334
No. of Share of SVU to be replaced = 43,334/225 = 192.5 or 193.
Total value of risk free investment to be brought in = ` [2,50,000 + (193 shares ×
225)] = ` 2,50,000 + 43,425) = ` 2,93,425
` 2,93,425 securities should be replaced.
Security No. of Shares MPS MV Beta Product
ADU 12,000 40 4,80,000 0.9 4,32,000
DVU 6,000 20 1,20,000 1.0 1,20,000
NDU 0 0 0 1.5 0
SVU 1,807 225 4,06,575 1.2 4,87,890
Risk free securities 2,93,425 0 0
13,00,000 10,39,890
Beta = 10,39,890 / 13,00,000 = 0.8

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