7402-Security Analysis and Portfolio Management

Editorial Board
Prof. Amit Kumar Singh

Department of Commerce, Faculty of Commerce and Business,
Delhi School of Economics, University of Delhi
Dr. Rohini Singh
Professor, Shaheed Sukhdev College of Business Studies,
University of Delhi
Content Writers
Dr. Rajdeep Singh, Dr. CA Madhu Totla, Mr. Amit Kumar,
Ms. Iti Verma, Anil Kumar, Rinki Dahiya
Academic Coordinator
Mr. Deekshant Awasthi
© Department of Distance and Continuing Education

ISBN: 978-81-19417-67-4
1st Edition: 2023
E-mail: [email protected]
[email protected]
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Department of Distance and Continuing Education
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© Department of Distance & Continuing Education, Campus of Open Learning,

Contents
PAGE
Lesson 1 : Introduction to Financial Investments
hi
1.1 Learning Objectives 1
1.2 Introduction
e l 2
1.3 Types of Investment
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1.4 Process of Investment 5
1.5 Avenues of Investment 6
1.6 Investment Environment
i ty 8
1.7 Investment Philosophies
r s 10
1.8 Investment Wisdom
v e 13
1.9 Summary
n i 15
1.10 Answers to In-Text Questions
, U 17
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1.11 Self-Assessment Questions 17
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1.12 References 18
1.13 Suggested Readings
/ S 18
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Lesson 2 : Fundamental Analysis, Technical Analysis, Equity Valuation and
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2.2 Introduction 21
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2.3 Fundamental Analysis
2.4 Valuation and Equity Pricing
22
24
2.5 Strategies of Investing 31
2.6 Technical Analysis 32
2.7 0DUNHW (I¿FLHQF\ DQG$QRPDOLHV
2.8 Summary 40
2.9 Answers to In-Text Questions 41
PAGE i
MBAFT 7402 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT
PAGE
2.11 References 42
2.12 Suggested Readings 43
Lesson 3 : Fixed Income

3.2 Introduction 45
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Importance of Bond Valuation 46
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3.3
3.4 Bond Pricing 47
3.5 Relationship between Bond Price and Yield
D 49
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3.6 Factors Affecting Bond Prices 50
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3.7 Bond Yields 51
3.8 Risks in Fixed Income Securities
s i 54
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3.9 Duration and Convexity 58
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3.10 Active Strategies of Fixed Income Investments 62
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3.11 Passive Strategies of Fixed Income 66
,
3.12 Summary 71
O L 72
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3.15 References
L / 73
C O
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Lesson 4 : Alternative Investments
4.1
4.2
C E
Learning Objectives
Introduction
74
75
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4.3 Real Estate Investments 79
4.4 Commodities Investing 85
4.5 Derivative Instruments 88
4.6 Other Alternative Asset Classes 93
4.7 Summary 99
4.10 References 103
ii PAGE
CONTENTS
PAGE
Lesson 5 : Modern Portfolio Theories

5.2 Introduction 105
5.3 Concept of Portfolio 105
5.4 Portfolio Management 105
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5.5 Concept of Portfolio Risk and Return 108
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5.7 Modern Portfolio Theories 115
5.8 Solved Illustrations 130
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5.9 Summary 136
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5.11 Self-Assessment Questions
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5.12 References
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U n 141
Lesson 6 : Asset Pricing

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6.1
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Learning Objectives 142
6.2 Introduction
L / 143
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6.3 Capital Assets Pricing Model (CAPM) 144
6.4
/ C
Extensions to the CAPM 150
6.5
C E
Arbitrage Pricing Theory 152
D
6.6 Active Portfolio Management 158
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6.7 Summary 163
6.8 Illustrations 164
6.11 References 167
6.12 Suggested Readings 168
PAGE iii
PAGE
Lesson 7 : Evaluation of Investment Performances

7.2 Introduction 171
7.3 Evaluation of Investment Performances 172
7.4 Measures of Portfolio Performance 174
i
7.5 Return Attribution 183
7.6 Portfolio Revision
l h 186
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7.7 Summary 190
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7.10 References 192
r s 193
Glossary
v e 195
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iv PAGE
L E S S O N
1
Introduction to
Financial Investments
Dr. Rajdeep Singh
Assistant Professor
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Department of Commerce
l h
University of Delhi
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Email-Id: [email protected]
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of
STRUCTURE
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1.1 Learning Objectives
1.2 Introduction
s i
e r
i v
n
1.4 Process of Investment
1.5 Avenues of Investment
, U
L
S O
L /
O
1.9 Summary
C
/ Questions
E
1.11 Self-Assessment
C
D
1.12 References
D
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To understand the meaning of Investment.
To understand the factors affecting Investment decisions.
To understand the various types of investment.
PAGE 1
Notes To understand the process of investment decisions.

To explain the various avenues of investment.
To understand the Investment Environment.
To understand the various Investment Philosophies.
To understand the concept of Investment Wisdom.
i
1.2 Introduction
l h
e
The allocation of resources, often money, with the goal of generating
D
future advantages or returns is referred to as investment. It entails devoting
of
capital to various assets such as stocks, bonds, real estate, mutual funds,
or enterprises with the hopes of producing income, capital appreciation,
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or both in the long run.
s i
The following are important investment concepts to understand:
e r
Risk and Return: Different investments carry varied degrees of risk.
i v
bigger-risk investments, in general, offer the potential for bigger profits,
U n
but they also involve a higher risk of loss. Low-risk investments typically
yield lesser returns. Finding the correct mix of risk and return is critical
L ,
based on a person’s risk tolerance and financial goals.
O
Diversification: Spreading assets across multiple asset classes (diversification)
S
L /
helps minimize portfolio risk. If one investment underperforms, the overall
portfolio suffers as a result.
C O
Time Horizon: The time horizon refers to how long an investor intends
E /
to retain an investment. Different investment instruments are appropriate
C
for various time horizons. Long-term investments may offer the possibility
D
of compounding returns, although short-term investments are sometimes
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more liquid.
Compounding: Compounding is the process by which an investment
generates returns that are reinvested to generate greater returns in
succeeding periods. Compounding can greatly raise the value of an
investment over time.
2 PAGE
INTRODUCTION TO FINANCIAL INVESTMENTS
Research and Analysis: Successful investment frequently necessitates Notes

extensive research and analysis of market patterns, economic indicators,
corporate financials, and other pertinent data.
Market Fluctuations: Due to market fluctuations, economic events, and
other factors, investment values might be erratic. Patience and a long-
term outlook are frequently required to navigate market ups and downs.
Before making investing decisions, individuals should evaluate their
i
financial situation, goals, risk tolerance, and investment knowledge.
Consultation with financial advisors or specialists can assist in tailoring
l h
an investing strategy to specific requirements and circumstances.
Meaning of Financial Investment:
D e
The allocation of funds with the expectation of creating a financial
of
ty
return or profit over a specific period of time is referred to as financial
i
investment. It entails devoting resources, such as money, to various financial
s
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instruments or assets in order to increase the value of the investment
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or generate income from it. Individuals, businesses, institutions, and
v
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governments make financial investments to attain certain financial goals.
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Important Points:
L ,
The basic goal of financial investment is to generate good financial outcomes
such as capital appreciation (growth in the value of the investment) or
S O
regular income (e.g., interest, dividends).
L /
Stocks, bonds, mutual funds, exchange-traded funds (ETFs), real estate,
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commodities, certificates of deposit (CDs), money market instruments,
C
/
and other financial assets are examples of financial investments:
C E
1. Risk and Return: The risk and possible return of various sorts of
financial investments differ. In general, investments with larger potential
D
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returns have a higher amount of risk.
2. Investment Horizon: Depending on the investor’s aims and time frame,
financial investments can be short-term, medium-term, or long-term. The
choice of investment tools is influenced by the investment horizon.
3. Diversification: Spreading investments across multiple asset classes and
industries in an investment portfolio can help control risk and improve
overall portfolio performance.
4. Liquidity: The ability of an investment to be converted into cash
quickly and without considerable loss of value is referred to as liquidity.
PAGE 3
Notes Some investments, such as publicly traded equities, are more liquid than
others, such as real estate.
5. Factors Influencing Investment Decisions: Market conditions, economic
outlook, interest rates, inflation, regulatory environment, and investor risk
tolerance all influence investment decisions.
6. Passive vs. Active Investing: Passive investing entails constructing
a diversified portfolio with the goal of replicating the performance of
i
a specific market index. Active investing entails picking and managing
individual investments in order to outperform the market.
l h
D e
7. Emotional Discipline: When making investment decisions, emotional
discipline is essential. Emotional reactions to market volatility might lead
of
to rash decisions that harm investment outcomes.
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8. Tax Considerations: Different investments may have different tax
i
consequences. It is critical to consider how investment gains and income
s
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are taxed.
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9. Financial Objectives: Investors have several financial objectives,
n i
such as saving for retirement, funding schooling, accumulating wealth,
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or creating income. The investments chosen should be in line with these
objectives.
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The investment process entails performing research, researching potential
S O
investments, estimating risk and return, making informed decisions, and
L /
monitoring and changing the portfolio on a regular basis. To summarize,
O
financial investing entails allocating resources strategically to various
C
financial assets with the goal of achieving financial growth, creating
E /
income, or both. Personal finance, asset management, and company
C
strategies all rely on it.
D
©D
Stocks: Stocks are ownership shares in a corporation that can increase
in value and pay dividends.
Bonds: Debt instruments issued by governments or corporations that
provide set interest payments and principal repayment.
Real Estate: Investment in tangible properties such as residential or
commercial real estate.
4 PAGE
Mutual funds and exchange-traded funds (ETFs): Pooled funds that Notes
invest in a diverse portfolio of assets managed by professionals.
Savings Accounts/CDs: Low-risk investments with good liquidity but
low yields.
Commodities, hedge funds, private equity, and other alternative investments
are examples. Individuals may invest for a variety of purposes, including
retirement planning, asset growth, paying education, or reaching financial
i
goals.
l h
1.4 Process of Investment
D e
of
The investment process consists of a set of processes that individuals or
organizations must take in order to make informed and strategic investment
i ty
decisions. While the specific procedure may differ depending on individual
r s
goals, risk tolerance, and investment experience, the following is a rough
e
summary of the investment process:
i v
Setting Investment Objectives and Goals: Define specific and attainable
U n
financial objectives, such as retirement planning, property ownership,
,
education finance, or wealth accumulation. Determine whether each goal’s
O L
time horizon is short-, medium-, or long-term.
Risk Evaluation: Assess your risk tolerance, which represents your level
/ S
of comfort with probable investing losses. Consider your age, financial
L
obligations, income stability, and investment experience.
O
/ C
Allocation of Assets: Determine how much of your investment portfolio
E
should be allocated to each asset class, such as stocks, bonds, real estate,
D C
and cash. Asset allocation seeks to balance risk and return in accordance
with your objectives and risk tolerance.
©D
Analysis and research: Conduct extensive study on potential investments
within your asset classes of choice. Examine financial statements, market
patterns, economic indicators, and any news or developments that are
pertinent.
Choosing an investment: Select specific investments that correspond to
your investment strategy and goals. Consider aspects such as past success,
management quality, fees, and development prospects.
PAGE 5
Notes Diversification: To reduce risk, diversify your investments among industries,

sectors, geographic locations, and asset classes. Diversification helps to
lessen the impact of a single investment’s poor performance.
Execution: After careful analysis and research, arriving at the final set
of investment options across various asset classes, industries, sectors, etc.
For instance, after having done proper research and analysis Mr. Rahul
finally holds a portfolio comprising stocks of Tata Steel Ltd.; Reliance
i
Industries Ltd. and Sovereign Gold Bonds.
Monitoring and evaluation: Review your investing portfolio on a
l h
D e
regular basis to ensure that it is still aligned with your goals and risk
tolerance. Changes in your financial circumstances or market conditions
of
may necessitate adjustments to your portfolio.
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Rebalancing: Rebalance your portfolio on a regular basis to maintain
i
the correct asset allocation. Rebalancing entails selling outperforming
r s
assets and purchasing underperforming ones to return your portfolio to
its target allocation.
v e
i
Keeping Up to Date: Keep up to date on market trends, economic
n
U
developments, and any changes that may affect your assets. Continue to
,
learn about investment techniques, possibilities, and risks.
O L
Considerations for Taxation: Consider the tax implications of your
financial choices. Investigate tax-saving methods such as tax-efficient
/ S
investing and the use of tax-advantaged accounts.
O L
Long-Term Prospects: Keep a long-term perspective in mind and avoid
C
making rash decisions based on short-term market volatility. Unless there
E /
are significant changes in your financial status or ambitions, stick to the
C
current investment approach.
D It is critical to understand that the investment process necessitates
©D
continual attention, adjustment, and a commitment to keeping educated.
Seek guidance from financial professionals to help you personalize your
investment approach to your specific circumstances and goals.
1.5 Avenues of Investment

Individuals and institutions can invest in a variety of ways, each with
a particular level of risk, return potential, and liquidity. Here are some
common investment options:
6 PAGE
Stocks (Equities): Investing in publicly traded company shares. Stocks Notes

offer the potential for high gains, but they also carry a higher level of
risk owing to market volatility.
Bonds (Fixed Income): Purchasing government or corporate debt
instruments. Bonds offer monthly interest and refund the principal at
maturity, making them less risky than equities.
Mutual Funds: Collectively managed funds that invest in a diverse range
i
of stocks, bonds, and other assets. Mutual funds, which are professionally
managed, provide diversity and are appropriate for investors with varied
l h
risk tolerances.
D e
of
ETFs are like mutual funds but are traded on stock markets like individual
stocks. ETFs provide diversification, transparency, and cheaper fees.
ty
Real Estate: Real estate investing refers to the purchase of tangible
s i
properties such as residential or commercial real estate. Rental income and
r
possible property value appreciation can be obtained through real estate.
e
i v
REITs are publicly listed organizations that own and manage income-
estate without physically owning properties.

U n
generating real estate assets, providing an opportunity to invest in real
L ,
Savings Accounts and Certificates of Deposit (CDs): Banks offer low-
O
risk choices with low interest rates and strong liquidity.
/ S
Commodities: Commodities are physical items such as gold, silver, oil,
O L
agricultural products, and so on. Commodities can be used to hedge
against inflation and diversify portfolios.
/ C
E
Investing in precious metals such as gold, silver, platinum, and palladium.
C
Precious metals can be used as a store of value as well as a hedge against
D
economic insecurity.
©D
Forex: The trading of currencies on the foreign exchange market. Forex
trading is highly speculative and necessitates a thorough understanding
of market dynamics.
Cryptocurrencies: Cryptocurrencies are digital or virtual currencies such
as Bitcoin and Ethereum. Cryptocurrencies are high-risk, speculative
investments.
PAGE 7
Notes Peer-to-Peer Lending: Investing in loans to individuals or small businesses

via internet platforms, with the potential for interest income.
Startup Investments: Making equity investments in early-stage enterprises
or startups. This is a high-risk, high-reward investment.
Hedge Funds and Private Equity: Investment funds that seek higher
returns through a variety of tactics, sometimes with minimal regulatory
monitoring and admittance only available to authorized investors.
Annuities: Annuities are insurance contracts that offer regular payments
h i
over time and are frequently used to plan for retirement income.
e l
D
Antiques: Investing in priceless art, antiques, rare coins, or other collecting
of
goods is known as art and collectibles. These investments might be illiquid
and necessitate specialized knowledge.
ty
Investing in education, training, and skill development to increase earning
potential and job options.
s i
e r
Before committing cash, it is critical to undertake thorough study and
i v
understand the characteristics, dangers, and potential returns of any
U n
investment channel. Diversification across several channels can aid in
risk management and the creation of a balanced portfolio that is aligned
L ,
with your financial goals and risk tolerance. Financial professionals can
O
provide significant insights and advice geared to your individual situation.
/ S
L
O
/ C
The investment environment refers to the different elements, situations, and
C Edynamics that influence investment decision-making and outcomes. These

variables can have a substantial impact on an investment’s prospective
D returns, hazards, and overall success. Economic conditions, market trends,
©D
regulatory regulations, geopolitical events, technical breakthroughs, and
other factors all contribute to the investing environment. The following
are some significant elements of the investment environment:
1. Economic Conditions: The state of the economy as a whole,
including elements such as GDP growth, inflation, interest rates,
and unemployment, can have a significant impact on investment
decisions. A healthy economy generally creates a favorable climate
8 PAGE
for investment, but a weak economy might raise uncertainty and Notes
risk.
2. Market Trends: Investment decisions can be influenced by trends in
many asset types such as stocks, bonds, real estate, commodities,
and cryptocurrencies. Understanding market patterns assists investors
in identifying prospective opportunities and risk management.
3. Government Laws: Government rules, policies, and tax laws can all
i
have a substantial impact on investment plans. Regulation changes
can have an impact on businesses, sectors, and specific investment
l h
vehicles.
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of
4. Location: Geopolitical events can add uncertainty and volatility
into the investment landscape, impacting investor mood and market
ty
performance.
s i
5. Technology: Technological innovations have the potential to offer
r
new investment possibilities, disrupt established sectors, and impact
e
v
consumer behavior. Staying up to date on developing technologies
n i
is critical for identifying prospective investment opportunities.
, U
6. Social Environment: Social and environmental aspects are increasingly
being considered by investors when making investment decisions.
O L
Environmental, Social and Governance (ESG) issues can influence
S
investor preferences and effect the attractiveness of specific projects.
L /
7. Market mood: Investor psychology, mood, and behavior all have an
O
impact on market patterns and asset values. Sentiment can fluctuate
C
/
between optimistic and pessimistic, influencing investment flows.
E
8. Global and Local issues: Global and local variables can both have
C
D
an impact on investments. Global economic events like the 2008
©D
financial crisis, as well as local events like changes in area rules,
can have a significant impact on investment outcomes.
9. Monetary Policy: Central bank policies, such as interest rate choices
and monetary stimulus packages, can have an impact on borrowing
rates, inflation, and overall market conditions.
10. Risk and Return: In the investment world, the link between risk
and potential return is critical. Investors examine their risk tolerance
and strive for a balance of prospective gains and potential losses.
PAGE 9
Notes 11. Investor Education and Information: Accurate and timely information
is essential for making sound investing decisions. Technological
improvements have increased access to information, allowing
investors to undertake thorough research.
12. Diversification: To distribute risk across different asset classes
and investments, investors frequently diversify their portfolios.
Diversification can help minimize risk while also increasing possible
i
profits.
The investment landscape is complex and ever-changing. Successful
l h
D e
investors are aware of these variables and adjust their strategy accordingly.
So every intelligent investor keeps in mind all the factors, situations and
of
latest technological changes before taking investment decisions. Making
informed selections requires due investigation, research, and a complete
awareness of the investment landscape.
i ty
r s
v e
n i
Investment philosophies are guiding principles and beliefs that influence
U
how an investor makes investment decisions. These ideas provide a
,
L
framework for investors to examine opportunities, manage risk, and
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allocate resources. Different investment philosophies represent different
/ S
views about risk, return, and the investment process as a whole. Here
O L
are some examples of common investment philosophies:
1. Value Investing: Value investors look for undervalued instruments,
/ C
such as stocks or bonds, that are trading at a discount to their
C E intrinsic or fair value. They believe that markets misprice assets
D
from time to time due to short-term swings of investor mood, and
©D
they want to profit from these differences.
2. Growth Investing: Growth investors are interested in companies
or assets that have a high potential for growth. Even though the
present price looks to be excessive, they select companies with
above-average profit growth and expansion possibilities. The idea
is to capture future value appreciation.
3. Income Investing: Income-oriented investors place a premium on
earning a consistent source of income from their investments. This
10 PAGE
sometimes entails investing in dividend-paying stocks, bonds, real Notes

estate, or other assets that pay out regular interest or dividends.
4. Index Investing: Index investors believe in the market’s efficiency
and strive to duplicate the performance of a certain market index,
such as the S&P 500. To attain wide market exposure, they employ
passive investment strategies such as index funds or exchange-traded
funds (ETFs).
i
5. Dividend Investing: Dividend-focused investors seek out equities
or funds that pay out steady dividends. Dividends may offer them
l h
stability and income, especially during market downturns.
D e
of
6. Contrarian Investing: Contrarian investors act in opposition to
market sentiment. When the market is pessimistic, they hunt for
ty
opportunities, and when the market is optimistic, they sell. This
i
viewpoint is based on the idea that market mood can cause mispricing.
s
r
7. Technical Analysis: Technical analysts use price movements,
e
v
trends, and past trading volumes to forecast future market behavior.
n i
They believe that historical price patterns can predict future price
U
fluctuations.
,
8. Fundamental Analysis: Fundamental analysts examine aspects such
L
O
as financial statements, earnings, cash flow, and industry dynamics to
S
determine an investment’s inherent value. They look for investments
L /
that are trading at a discount to their intrinsic worth.
O
9. Long-Term Investing: Long-term investors place a premium on
C
/
holding investments for a long length of time, frequently years or
C E
even decades. They trust in the power of compounding and are less
worried with market changes in the short term.
D
©D
10. Social Analysis: Socially Responsible Investing (SRI) / Environmental,
Social, and Governance (ESG) Investing: When making investment
decisions, SRI and ESG investors consider ethical, social, and
environmental factors. They try to match their investments to their
values and may avoid corporations in contentious areas.
11. Quantitative Investing: Quantitative investors make investment
judgments based on mathematical models and data analysis. To
discover trends and execute trades, they frequently rely on computer
algorithms.
PAGE 11
Notes 12. Hedge Fund Strategies: Hedge funds use a variety of strategies to
generate returns that are uncorrelated with broader market movements,
such as long/short equities, event-driven, and macroeconomic.
Individuals may use a combination of these investment philosophies or
develop their own unique method depending on their financial goals, risk
tolerance, and values. Successful investors frequently perform extensive
study, exercise discipline, and adhere to their chosen investment philosophy.
i
Investment wisdom is the cumulative knowledge, insights, and concepts
l h
gained through time by experienced investors through their observations,
D e
successes, mistakes, and continual learning. This expertise is frequently
condensed into concise and valuable pieces of advice that can help
of
individuals make informed and cautious investing decisions. Here are
some timeless investment pearls of wisdom:
i ty
1. “Buy Low, Sell High”: This timeless adage underlines the necessity
r s
of investing when assets are undervalued and selling when they are
e
overpriced. It is a fundamental premise of profit-seeking investing.
v
n i
2. “Diversification Reduces Risk”: Spreading your investments across
U
several asset classes can help lessen the impact of poor performance
,
in any one area and lower your portfolio’s overall risk.
L
O
3. “Time in the Market, Not Timing the Market”: Long-term investing
S
and remaining invested are more important than predicting short-
L /
term market changes.
O
4. “Don’t Put All Your Eggs in One Basket”: Avoid putting all of your
C
/
investment cash into a single asset or firm, as this might expose
C E you to severe risk if that investment underperforms.
D
5. “Understand What You Invest In”: Thoroughly research and
©D
comprehend the investments you’re thinking about making. Knowledge
is your best line of defense against making rash decisions.
6. “Patience is a Virtue”: Successful investment frequently necessitates
patience. Allowing your investments to compound over time can
result in considerable compounding and improved long-term results.
7. “Emotions Can Cloud Judgment”: Emotional decision-making can
result in impulsive behavior. Maintain a logical attitude to investing,
even when markets are volatile.
12 PAGE
8. “Don’t chase performance”: Just because an investment has Notes

performed well recently does not guarantee future success. Make
no investment decisions based purely on historical performance.
9. “Stay Invested Throughout Market Cycles”: Markets experience ups
and downs. It is critical to stay involved and avoid the temptation
to sell during market downturns, as markets tend to recover over
time.
i
10. “Know Your Risk Tolerance”: Recognize your risk tolerance and
invest accordingly. Don’t take on more danger than you can handle.
l h
11. “Avoid Herd Mentality”: Just because everyone else is investing in
D e
of
a particular asset does not mean it is the best option for you. Make
no investment decisions based entirely on what others are doing.
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12. “Keep Costs Low”: Over time, high fees and expenses can eat into
s i
your investment profits. When possible, choose low-cost investment
solutions.
e r
i v
13. “Invest for Goals, Not Noise”: Rather than getting caught up in
goals.
U n
short-term market noise or fads, focus on your long-term financial
L ,
14. “Continuous Learning is Critical”: The investment landscape is
O
constantly changing. Stay informed by reading, researching, and
/ S
adjusting your strategy in response to new knowledge.
O L
15. “Have an Exit Strategy”: It is critical to plan when to sell an
investment. Having an exit strategy can help you make reasonable
/ C
decisions, whether it’s to meet a specific price target or to adjust
E
to changing conditions.
C
D
©D
Keep in mind that investment knowledge is not a one-size-fits-all solution.
When implementing these ideas to your own investment strategy, keep
in mind your personal financial status, goals, and risk tolerance. Every
individual and organisations have their own set of goals, priorities and
environment which is different for every organisation so keeping in mind
their culture and objectives every individual and organisation decide for
their investment decisions.
PAGE 13
Notes IN-TEXT QUESTIONS

1. What is the primary goal of diversification in an investment
portfolio?
(a) To eliminate all risk
(b) To maximize potential returns
(c) To reduce overall portfolio risk by spreading investments
i
across different assets
(d) To focus solely on high-risk, high-reward assets
l h
D e
2. Which investment philosophy focuses on identifying undervalued
of
assets that are trading below their intrinsic value?
(a) Growth investing
(b) Index investing
i ty
(c) Value investing
r s
(d) Dividend investing
v e
n i
3. What does the term “ROI” stand for in the context of investments?
U
(a) Rate of Inflation
,
L
(b) Return on Investment
O
(c) Risk of Investment
S
L /
(d) Ratio of Income
O
4. Which investment vehicle is designed to track the performance
C
/
of a specific market index?
CE
(a) Mutual fund
D
(b) Real estate property
© D (c) Individual stock

(d) Exchange-Traded Fund (ETF)
5. What is the general relationship between risk and potential
return in investments?
(a) Higher risk is always associated with higher potential return
(b) Higher risk is always associated with lower potential return
14 PAGE
(c) There is no relationship between risk and potential return Notes
(d) Risk and potential return are independent factors

6. What is the term for an investment strategy that involves buying
and holding investments for an extended period, often years or
decades?
(a) Day trading
i
(b) Swing trading
(c) Active investing
l h
(d) Long-term investing
D e
of
7. Socially Responsible Investing (SRI) takes into account which
factors when making investment decisions?
(a) Only financial factors
i ty
(b) Only environmental factors
r s
(c) Only social factors
v e
n i
(d) Environmental, Social and Governance (ESG) factors
U
8. Which of the following investment options typically carries the
,
L
highest level of risk?
(a) Government bonds
S O
(b) Blue-chip stocks
L /
O
(c) Certificate of deposit (CD)
/ C
(d) Startup company equity
1.9 Summary
C E
D
©D
The act of allocating financial resources to diverse assets with the goal
of earning returns over time is known as investing. It entails making
decisions on where to invest money in order to meet specific financial
objectives. The investing process includes a variety of factors, techniques,
and concepts that influence individuals and institutions in their quest of
wealth building and financial security.
PAGE 15
Notes Important Points:

The basic goal of investment is to increase wealth by receiving a return
on the cash invested. Capital appreciation, interest, dividends, or rental
income can all be used to generate this return.
Diversification: To reduce risk, diversify a portfolio by distributing
assets among several asset classes (such as stocks, bonds, real estate, and
commodities). Diversification seeks to protect against a single investment’s
i
poor performance.
l h
Risk and reward: Generally, investments include a trade-off between risk
D e
and potential reward. bigger-risk investments have the potential for bigger
of
returns, but they also carry greater uncertainty and the chance of loss.
Investing Philosophies: Various investment philosophies influence
ty
decision-making. These include value investing (looking for discounted
s i
assets), growth investing (looking for high-growing companies), income
r
investment (looking for consistent income), and others.
e
i v
Long-Term View: Long-term investing focuses on holding investments for
U n
a lengthy period of time in order to profit from the power of compounding
and ride out short-term market volatility.
L ,
Due Diligence and Research: Successful investing necessitates extensive
O
research and analysis. Investors should comprehend the basics of the
/ S
investments they select and stay current on market movements and
O L
economic situations.
Asset Allocation: Choosing how to allocate investments across different
/ C
asset classes is an important part of investment strategy. The asset mix
C Echosen should correspond to an investor’s risk tolerance, goals, and time
D
horizon.
©D
Stocks, bonds, mutual funds, exchange-traded funds (ETFs), real estate,
commodities, and other investment vehicles are all available. Each has
its own set of qualities, advantages, and disadvantages.
Market Timing vs. Market Timing: Attempting to time the market
(predicting short-term price fluctuations) is difficult and risky. A better
strategy is to focus on time in the market and stay invested for the long
term.
16 PAGE
Investment Risks: There are inherent risks in all investments, including Notes
market risk, interest rate risk, credit risk, and liquidity risk. Understanding
and controlling these risks is critical for profitable investing.
Emotional Discipline: Emotions have the potential to influence financial
decisions. Maintaining emotional control and avoiding impulsive decisions
are critical to meeting investment goals.
Monitoring and Adjustments: Regularly assessing investment performance
i
and making necessary adjustments to the portfolio will assist guarantee that
it remains aligned with changing financial goals and market conditions.
l h
D
Finally, investing entails making informed decisions about allocating financial
e
of
resources to diverse assets in order to achieve financial development and
security. Research, discipline, risk management, and a long-term view are
ty
all required for successful investing.
s i
e r
i v
1. (c) To reduce overall portfolio risk by spreading investments across
different assets
U n
2. (c) Value investing
L ,
O
3. (b) Return on Investment
/ S
4. (d) Exchange-Traded Fund (ETF)
L
5. (a) Higher risk is always associated with higher potential return
O
C
6. (d) Long-term investing
E /
7. (d) Environmental, Social and Governance (ESG) factors
C
8. (d) Startup company equity
D
©D
1. What do you mean by investment decisions? Explain the process
of Investment.
2. Explain the types of Investment.
3. Write a note on various avenues of investment.
PAGE 17
Notes 4. Explain the Concept of philosophies of Investment.

5. Write a note on Investment wisdom.
1.12 References
Bodie, Z., Kane, A. & Marcus, A. J. (2017). Investments. New York:
McGraw Hill Education.
i
Chandra, P. (2017). Investment Analysis and Portfolio Management.
Delhi: McGraw Hill Education.
l h

D e
Elton, E. J., Gruber, M. J., Brown, S. J. & Goetzmann, W. N. (2014).
of
Modern Portfolio Theory and Investment Analysis. USA: John Wiley
& Sons.
ty
Fischer, D. E. & Jordan, R. J. (1995). Security Analysis and Portfolio
s
Management. New Delhi: Pearson Education.
i

e r
Holden, C. W. (2014). Excel Modeling in Investments. England:
Pearson Education.
i v

U n
Ranganathan, M. & Madhumathi, R. (2012). Investment Analysis
and Portfolio Management. Delhi: Pearson Education.

L ,
Reilly, F. K., Brown, K. C. & Leeds, S. J. (2018). Investment Analysis
O
& Portfolio Management. Delhi: Cengage Learning.
S

L /
Sehgal, S. (2005). Asset Pricing in Indian Stock Market. Delhi: New
O
Century Publications.
/ C
E
D C Bodie, Z., Kane, A. & Marcus, A. J. (2017). Investments. New York:
©D
McGraw Hill Education.
Delhi: McGraw Hill Education.
& Sons.
18 PAGE
Holden, C. W. (2014). Excel Modeling in Investments. England: Notes

Pearson Education.
Reilly, F. K., Brown, K. C. & Leeds, S. J. (2018). Investment Analysis
h i
e l
D
of
i ty
r s
v e
n i
, U
O L
/ S
O L
/ C
C E
D
©D
PAGE 19
L E S S O N
2
Fundamental Analysis,
Technical Analysis, Equity
Valuation and Market
Efficiency
h i
e
Dr. CA Madhu Totlal
D
Assistant Professor
of
Department of Management Studies
ty
Shaheed Sukhdev College of Business Studies
i
University of Delhi
r s
v e
STRUCTURE
n i
, U
2.2 Introduction
O L
S
2.3 Fundamental Analysis
L /
O
2.5 Strategies of Investing
C
/ DQG $QRPDOLHV
2.6 Technical Analysis
E
C
2.7 0DUNHW (I¿FLHQF\
D
2.8 Summary
D
2.10©Self-Assessment Questions
2.11 References
20 PAGE
FUNDAMENTAL ANALYSIS, TECHNICAL ANALYSIS, EQUITY VALUATION
2.1 Learning Objectives Notes
To understand the relationship between prices of the stock and the

economy.
To understand the information available from various sources and
decide about the future of the economy.
To understand the relationship between the economy and the industry.
To determine various factors influencing industries.
h i
To understand the implication of new information on various
e l
D
industries and their future prospects.
of
To understand evaluation of the operational and financial health of
a company.

i ty
To understand the active and passive strategies of investing.

r s
To estimate the fair value and intrinsic value of a share.

v e
To understand the various tools of technical analysis.

n i
To learn about the various forms of efficiency in the stock market.
2.2 Introduction
, U
O L
S
Investment in equity has to be made on the basis of an in depth analysis.
L /
It cannot be just done on the basis of rumours and speculative motives.
O
Rather it requires a rational analysis of the company, industry and the
C
economy along with the study of the past patterns and forecasting the
E /
future prices. Analysis of the economy, industry and the company, being
C
referred to as the EIC framework is known as the fundamental analysis.
D
Also, as the share prices are quite volatile and uncertain, the past
©D
behaviour of these prices is analysed with the help of charts and patterns
to understand the future equity prices and the stock market. This use of
charts of patterns is being referred to as technical analysis. Even though
equity share prices and the stock market cannot be predicted with accuracy
both the fundamental and the technical analysis help to make rational
investment decisions.
PAGE 21
Notes 2.3 Fundamental Analysis

Fundamental analysis is a systematic approach to estimate the true values
of the share and the corresponding return. It is the analysis of the various
determining factors of the fair value of the share. It basically includes
analysing the economy, industry and the company.
Fundamental analysis consists of two approaches: “Bottoms up approach”
and “Top down approach”. The Bottoms up approach is for small investors
h i
who directly analyse the company with focus on its financial statements,
e l
competitive strength and market position. This approach does not require
D
investor to analyse the economy and the industry. Whereas the “Top
of
down Approach” in the fundamental analysis is the study of the economic
scenario in which the company operates, then moving on to the study of
ty
the industry prospects, followed by the specific company analysis.
Top Down Approach
s i
e r
i v Company
U n Analysis
,
Industry
O L Analysis
/ S Economic
O L Analysis
/ C
C E
D
©D 2.3.1 Economic Analysis
Economic analysis is the study of the various forces operating in the
overall economy. The overall economic conditions and the economic
activities do impact the company’s profits thereby impacting the share
prices. If the economic analysis depicts a strong picture, investors will buy
the shares with expectation of increased share prices and high profits in
22 PAGE
future whereas if the economic analysis shows a weak future, industries Notes
will struggle to survive and there would be selling pressure leading to
decline in the share prices. Economic analysis entails analysing both the
international as well as the country specific economy. The international
economy does affect both the direct and the portfolio investments
coming into the country and thus leading the change in the stock market.
Regarding the domestic economy, one needs to analyse various variables
like inflation, interest rates, GDP, fiscal and monetary policies, business
cycles, level of competition etc. The economic analysis requires a lot of
h i
expertise and is a tedious exercise.
e l
D
of
2.3.2 Industry Analysis
ty
With the economic analysis the direction of the movement of economy
i
is identified however, different industries respond in a different manner.
s
r
This makes industry analysis an important part of the fundamental
e
v
analysis. Industry analysis entails analysing the industry life cycle, labour
n i
conditions, market conditions, stage of competition, government policies
U
regarding that industry, past performance of the industry, availability of
L ,
raw material for that industry, level of technology and its permanence
and so on. The industry life cycle analysis helps to determine whether
O
that industry is in the introduction stage or expansion stage. These stages
S
L /
would attract investment whereas the stagnation and the decay stage of
the industry would lead to pulling out money from the industry.
C O
E /
2.3.3 Company Analysis
D C
After the economic and the industry analysis, fundamental analysis provides
©D
for the company specific analysis. The company specific analysis has the
objective of: (a) forecasting the earnings of the company (b) finding out
the intrinsic value of the share.
Intrinsic or fair value of the share depends majorly on the forecasted
earnings capacity of the company along with leverage, asset utilisation,
sales, operating profit margin etc. For forecasting the future earnings,
a study of the company’s past financial statements and annual report is
undertaken. These financial statements include the balance sheet, profit
and loss account, cash flow statement and the notes to accounts. The
PAGE 23
Notes information extracted from these sources is used to analyse the profitability,
liquidity and solvency of the company. The method of determination of
intrinsic value of the share has been discussed subsequently in this chapter.
However, the various ratios being analysed for profitability analysis are:
return on equity, earnings per share, price to earnings ratio, dividend
pay-out ratio, earnings yield and dividend yield ratio.
Investors also use the concept of Economic Value Added (EVA) as
i
profitability measure while doing company analysis. EVA is what is earned
l h
over the cost of funds employed. It’s the operating profit less the cost of
e
capital. Higher EVA adds more wealth to the shareholders net worth and
D
therefore such companies command better valuation in the stock market.
of
A company can increase EVA through increasing its operating efficiency,
liquidating unproductive capital and accepting new projects which give
ty
higher returns than the cost of new funds.
s i
e r
i v
n
Valuation of equity shares is a bit complicated owing to their residual
, U
ownership characteristic. Equity shares neither have a guaranteed dividend
nor the rate remains constant over the life of the share. With these
O L
differences from bonds and preference shares, the valuation method used
S
for bonds and preference shares cannot be used for valuing equity. The
L /
various different approaches in valuing equity shares are:

C OValuation based on accounting information
E / Valuation based on dividend
C
Valuation based on earnings
D D 2.4.1 Valuation Based on Accounting Information

© The information extracted from the financial statements is sufficient to
determine the value of an equity share. Based on accounting information,
we can use the book value method and the liquidation value method for
valuing equity shares.
Book Value method: This method values equity shares based on the stated
values of the assets and liabilities in the balance sheet. Book value of an
equity share is the value of firm’s ownership divided by the number of
24 PAGE
outstanding equity shares. The underlying assumption is that all the assets Notes
are expected to realise the values stated in the balance sheet. The book
value method of valuing equity shares is one of the simplest techniques
of valuation but at the same time it ignores the profit making capacity
of the company and also the book values are the historical values which
are outdated.
Liquidation Value method: This method values equity shares based on the
i
realisable value of the asset minus the liabilities to be paid. This concept
of liquidation value is actually the value; the holder of one equity share
l h
e
will receive if the company goes into liquidation immediately.
Amongst the book value and liquidation value method, liquidation value
D
of
method is more realistic but this method also fails to consider the profit
earning capacity of the company and also determining the net realisable
value of all assets is also a tedious task.
i ty
r s
2.4.2 Valuation Based on Dividends
v e
n i
Value of an equity share is the sum of the present value of expected
U
benefits from holding of the equity share. Though paying dividend on
,
L
equity shares is not mandated by law companies do pay dividends to
O
satisfy the expectation of equity holders. This valuation method is based
/ S
on the assumption that dividend is payable annually only and the first
O L
dividend is received only at the end of year one.
Value of equity shares for companies which pay dividend every year and
/ C
the investor holds it for a given finite time period (n) is given by:
CE … Dn
D1 D2
P0 = ∑tn=1 + 2 +
D (1+ K e ) n
1
(1+ K e ) (1+ K e )
©
Where, D
D1/D2/Dn = Dividend expected at the end of year 1/year 2 and so on
P0 = Value of the equity shares
ke = Required rate of return of the equity shareholders specific to that
risk class
PAGE 25
Notes For companies where there is no growth in dividends i.e. the company
pays constant dividend for infinite period of time, the value of equity
share is given by:
D
P0 =
ke
Where,
D = Constant dividend expected at the end of every year
h i
e l
risk class
D
of
The constant dividend model significantly helps in valuing equity shares,
ty
but the major shortcoming is that the dividend does not remain constant
i
over the holding period and also the holding might not be till perpetuity.
r
For companies which do not pay the same amount of dividend every
s
v e
year and the dividend grows every year at a constant rate, the value of
equity share is given by:
n i
, U P0 =
D1
ke − g
Where,
O L
/ S
D1 = Dividend expected at the end of year 1
O L
P0 = Value of the equity share
/ C
C Erisk class
D
g = Growth rate in dividends provide g < ke
©D
The constant growth model is an important model for valuing equity
shares, but the underlying assumption of constant growth rate in dividends
is not practical and in real life the dividend grows at varying rates.
For companies, which pay dividend growing at different rates, the value
of equity share can be determined using
D 0 (1+ g 1 ) D5 (1+ g 2 ) D10 (1+ g 3 )

t t −5 t −10
5 10 ∞
P0 = ∑ +∑ +∑
t =1
(1+ K e ) t t =6
(1+ K e ) t t =11
(1+ K e ) t
26 PAGE
Where, Notes
D0 / D5 / D10 = Dividend at the end of respective time period
P0 = Value of the equity share
risk class
g1/ g2 / g3= Different growth rate in dividends for different time periods
i
In case of finite holding period, the value of equity share can be determined
using:
l h
P0 =
D1 + P1
(1+ k e )
D e
Where,
of
ty
D1 = Dividend expected at the end of year one
s i
r
e
P1 = Expected market price of the equity share at the end of year one
v
n i
U
risk class
,
To use this valuation method, the investor needs to estimate the market
L
O
value at the end of year one.
Example 2.1
/ S
O L
7KHGLYLGHQGH[SHFWHGDWWKHHQGRIFXUUHQW\HDULVൗDQGWKHUHTXLUHG
rate of return appropriate for that risk class is 15%. Determine the current
/ C
value of the equity share using the constant dividend model.
C E
Solution: Where the company pays constant dividend for infinite period
D
of time, the value of equity share is given by:
©D P0 =
D
ke
Given,
D
ke = 15%
PAGE 27
Notes
P0 =
0.15
P0 = 720
7KH YDOXH RI HTXLW\ VKDUH LV ൗ

Example 2.2
7KH GLYLGHQG H[SHFWHG DW WKH HQG RI FXUUHQW \HDU LV ൗ DQG WKH
required rate of return appropriate for that risk class is 12%. Determine
h i
the current value of the equity share if the dividend grows at a given
constant rate of 4%.
e l
D
of
Solution: For companies which do not pay the same amount of dividend
every year, but the dividend grows at a constant rate g every year, the
ty
value of equity share is given by:
D1
s i
r
P0 =
ke − g
v e
Given,
n i
U
D = 210
ke = 12%
L ,
O
g = 4%
/ S 210
L
P0 =
.12 – .04
CO
P0 = 2625
E /
7KH YDOXH RI HTXLW\ VKDUH LV ൗ
D C Example 2.3
© D $PDQ /WG IRUHFDVWV D JURZWK UDWH LQ GLYLGHQGV RI SHUFHQW SD IRU
next 2 years and which is then likely to fall at 5 percent p.a. and get
VWDELOLVHG WKHUH 7KH ODVW \HDU GLYLGHQG ZDV ൗ DQG WKH H[SHFWHG UDWH
of return of equity investors of this risk class is 10 per cent. Determine
the value of one equity share of Aman Ltd. using the varying growth
rate dividend model.
Solution: Value of an equity share of Aman Ltd. (with varying growth
rate in dividends) will be the sum of the present values of (i) dividends
28 PAGE
during years 1 and 2 and (ii) the expected market price immediately after Notes
2 years, with a constant growth rate of 5% p.a.
The present value of dividends of year 1 and 2
Years Dividends PVIF (10%) PV of dividends
1 .909
2 11.664 9.73
Total 19.55
Immediately, at the end of year 2, the market price of the equity share
h i
will be
e l
D3
D
of
P2 =
ke − g
ty
12.6
P2 =
i
.10 – .05
P2 = 252
r s
v e
Present value of ൗ î ൗ
n i
U
)DLUYDOXHRIWKLVHTXLW\VKDUHDVRQGDWHLVൗൗ ൗ
2.4.3 Valuation Based on Earnings

L ,
S O
L /
Some firms do not pay any dividend rather believe in retaining the
earnings (partly or fully) for reinvestment in their expansion projects. As
C O
these firms are growth firms investors are willing to forego the current
/
dividends in expectation of higher dividends in future. There are various
E
C
approaches and models for determining the value of equity shares on the
D
basis of earnings of the company.
©D
Earnings multiplier Approach: The most common approach to value
an equity share is the price to earnings ratio. As per this approach value
of an equity share is:
9DOXH (36 î P/E Ratio
P/E ratio of the company is Market price divided by earning per share
and is being used as a performance measure. In this approach, estimation
of the P/E ratio is the most complicated task. One way is to use the
PAGE 29
Notes industry P/E or the nearest competitor P/E which needs to be further
adjusted as per the peculiar characteristics of the company.
Though this approach is the most widely used at the same time it suffers
from certain misunderstandings. A high P/E ratio is not always good as
it may be due to low EPS and similarly a low P/E ratio may not be bad
if it is from high EPS.
Gordon’s Model: This model is based on the assumption that retention
i
ratio remains constant and secondly return on investment or reinvestment
remains constant. Thus, it assumes that earnings of the company are
l h
equity holders.
D e
either reinvested at the given reinvestment rate or distributed among the
The value of equity share is given by:

of
ty
EPS 1 (1 − b)
i
P0 =
k e − br
r s
Where,
v e
n i
EPS1 = Earnings expected at the end of year one
P0 =
U
Value of the equity shares
,
L
b = retention ratio (percentage of earnings retained by the company)
ke =
O
Required rate of return of the equity shareholders specific to that
S
/
risk class or the cost of equity capital
r =
L
Return on investment
O
C
With this model, the value of the equity share will be high if the company
E /
is a growth firm and has a high retention ratio whereas if the company is
C
a declining firm, a lower retention ratio or a 100% pay-out ratio would
D maximise the value of the equity share.
©D
Walter’s Model: As per this model of equity valuation, the value of an
equity share is the sum total of the present value of an infinite stream of
dividends and the present value of the infinite stream of returns earned
from the investment of retained earnings. The model can be given by:
D r / k e (E − D)
P0 = +
ke ke
30 PAGE
Where, Notes
D = Dividend per share
E = Earnings per share
risk class or the cost of equity capital
r = Rate of return on investment
h i
l
Thus, this model consists of the sum of two present values. The first
phrase in the equation is the present value of dividend till perpetuity and
the second phrase is the present value of an infinite stream of return on
D e
of
retained earnings. So, depending upon the relationship of r and ke investors
will value the equity share accordingly.
IN-TEXT QUESTIONS
i ty
1. Dividend discount model of equity valuation:
r s
v e
i
(a) Implicitly incorporates capital gain
(b) Ignores the amount of capital gain
U n
,
(c) Includes capital gains after tax adjustment
(d) Cannot say
O L
S
2. The sum of present value of all expected benefits to an investor
L /
from holding of equity share is _________.
O
(a) Retention ratio
C
/
(b) Intrinsic value
E
C
(c) Market capitalisation
D
(d) None of these
©D
2.5 Strategies of Investing
The investment process is to determine where to invest (asset class)
and when to invest. The answer to – where to invest, consists of asset
allocation and the security selection. Asset allocation is to allocate the
investible funds to different asset classes like real estate, gold, equity
shares, preference shares, bonds etc. There is no standard rule for asset
allocation to each of these classes, rather it is the choice of the investor
PAGE 31
Notes based on his risk appetite. After the asset allocation, the next step is to
select the specific security. In case of equity shares, it involves an in
depth analysis. The prominent strategies for investing in equity shares are:
Active Strategy
Passive Strategy
2.5.1 Active Strategy
h i
l
Active Strategy is to study and analyse the individual securities and
D e
then select the specific security for investment. This strategy is based on
the premise that an investor has more information than other investors
of
and is equipped to analyse the securities. The investor using an active
strategy identifies the undervalued securities and invests in them and
i ty
simultaneously also identifies the overvalued securities and sells them.
r s
During this process, the investor also identifies the high growth shares
e
and makes investment in them. With these actions, the investor tries to
“beat the market”.
i v
2.5.2 Passive StrategyU n
L ,
O
This strategy entails investing in the market directly i.e. the index. The
/ S
investor does not engage into individual security analysis rather buys the
L
market index and gets the return which the market offers. An investor
O
while using the passive strategy may either buy and hold the market index
C
/
directly or may invest in the index funds of mutual funds. These index
C E
funds invest their corpus in equity shares in the same proportion as the
benchmark index. There are different index funds options available and
D D the investor has to carefully select the particular index fund.
© 2.6 Technical Analysis

Technical analysis is the study of the past prices and trends using charts
and patterns to forecast the future prices and movements. The basic
premise of technical analysis is that the past information on prices and
volume give an idea of what lies ahead. The trend in prices is believed
to continue and is used to predict the future.
32 PAGE
Technical analysis is a reflection of the idea that the stock market moves Notes
in trends and that the direction is maintained unless a reversal of the
trend is indicated. Technical analysis is based on the phrase that the
“market narrates its own story”. A technical analyst identifies the trend
in the prices and the point where the trend ends and prices start moving
in the opposite direction.
Technical analysis is based on certain assumptions:
i
Prices of any security in the market are determined by the demand
and supply forces.
l h
Share prices tend to move in one direction for a long period.
D e
of
Change in demand and supply will lead to a shift in trend and this
change in demand and supply can be detected earlier with the help
ty
of charts and graphs.

s i
These price patterns tend to repeat themselves and can be used to
forecast the future prices.
e r
i v
Tools and techniques used in technical analysis are: charting and market
indicators.
U n
,
Charting
L
Charting is the basic tool of technical analysis, where charts are prepared
O
S
using the past closing prices of the stocks. X axis shows time and Y axis
shows the prices.
L /
O
Dow Theory: Charles Dow: Father of technical analysis, said that stock
/ C
prices do not behave randomly rather follow a specific trend. The three
E
trends exhibited are- primary trend, secondary trend and minor trend.
C
Primary trend in stock prices lasts for a long time which may extend
D
©D
to many years. This trend may be bearish or bullish. Secondary trend
exists within the primary trend and lasts for a few days to a few months.
Secondary trends are the corrections in the primary trend. Minor trends
are the day to day movements in the prices, have little analytical value
as they are for a very short duration.
PAGE 33
Notes
h i
e l
D
of
Figure 2.1: Dow Theory
ty
Dow Theory states that the primary trend cannot be manipulated and the
investors need to wait for trend reversal.
s i
e r
Elliott Wave Theory: This theory is based on the preposition that stock
v
prices behave in a set of wave patterns and that the long term major
n i
pattern consists of five waves or patterns. In a bull market the first wave
U
is upward whereas in a bear market the first wave is downward.
L ,
Both Dow Theory and Elliott Wave Theory both identify the long term
O
trend with short term deviations and are easy to understand. The price
S
volume charts use both the price as well as volume data to understand
L /
the past and forecast the future behaviour.
O
For plotting the prices on charts to study trends, patterns and indicators,
C
/
prices need to be adjusted for stock splits and bonus issues. These charts
C Ecan be prepared using free software. Some of the price charts developed
and used are:
D
©D
Bar chart: These charts use vertical bars for depicting price for each
month or week or daily. These bars show the highest and the lowest price
and a single horizontal line depicting the closing price.
Line chart: Line chart uses a line to join data points which may be
monthly or weekly or daily closing prices or moving averages of prices etc.
Point and figure chart: These charts have no time scale; they just show
significant positive and negative changes in price. A column of Xs shows
increasing price whereas a column of Os shows decreasing price. Xs and
Os are added only when the price changes beyond a predefined range.
34 PAGE
Candlestick chart: These are similar to bar charts but differ in the visual Notes
impact. Opening and closing price are used to form a box and the bar
depicts the high and low prices. If the closing price is higher than the
opening price, the box is left empty and if its other way round, the box
is coloured in black.
h i
e l
D
of
i ty
r s
v e
n i
, U
O L
/ S
(Source: Finowings.com)
O L
Support and Resistance levels charts: These levels indicate an end of
C
the declining or increasing trend. The trend is expected to take U turn
E /
and reverse the direction at both these levels. Support level is the price
C
level below which the prices are not supposed to fall and resistance
D
level is that price level beyond which the price is not expected to rise.
©D
In case of price fall below the support level, it’s a bear signal and in
case of price rise beyond the resistance level, it’s considered as a bull
signal. However, these levels are indicative only and the range between
them may change anytime.
The common price patterns which are being observed in these charts are:
Trend, Head and Shoulders, Inverted head and shoulders, Double top and
bottom, Triangles.
PAGE 35
Notes Indicators: Indicators are a mathematical output of various calculations

done using price and volume data to measure trend, volatility and
momentum. These indicators help in predicting the direction of the price
movement in near future. Various indicators being used to predict are:
Moving Averages: Moving averages of share prices evens out the price
data and it’s the average level of the closing prices calculated regularly.
A sequence of average is calculated by using the daily averages. The
i
moving average line is a visual presentation of the price behaviour of
l h
the share prices. When the price line cuts the moving average line from
e
below, it’s a buy signal and when it cuts from above it’s a sell signal.
D
Moving Average Convergence Divergence (MACD): It’s a momentum
of
indicator and a combination of leading and lagging indicators. This uses
two moving averages, where the longer moving average is subtracted
i ty
from the shorter moving average. On the chart, it appears as two lines
r s
which fluctuate without limits. Intersection of these two lines generates
e
indications- crossing above zero is regarded bullish and crossing below
v
zero is regarded bearish.
n i
U
Breadth indicators: These indicators indicate market strength and
,
weakness. It’s a ratio of number of stocks advancing to number of stock
O L
declining in the market. It does not give any signal at its own but helps
in understanding the overall scenario of the market.
/ S
L
IN-TEXT QUESTIONS
O
3. Technical analysis is based on the concept that prices ________.
C
/ (a) Move upwards only
CE
(b) Move downwards only
D D (c) Move randomly
©
(d) Move in trends
4. The area in the chart where price has difficulty breaking through __.
(a) Support level
(b) Resistance level
(c) Both of these
(d) None of these
36 PAGE
5. Bar charts are a series of________ representing each data point. Notes
(a) Slanting lines

(b) Vertical lines
(c) Any of these
(d) None of these
6. The two primary tool of technical analysis are:
(a) Economic indicators and market index
h i
(b) Price and earnings
e l
(c) Price and volume
D
of
(d) Market index and earnings
2.7 Market Efficiency and Anomalies

i ty
r s
e
The stock market is the place for buying and selling of shares at prevalent
v
n i
market prices. These market prices keep on fluctuating regularly. The
fluctuation is partly on account of the new information getting available
, U
every now and then. The prevailing stock prices get adjusted to these
O L
new pieces of information. The speed at which this movement in prices
happens and attain equilibrium is dependent on the market efficiency.
/ S
The market efficiency may be defined as its ability to reflect the effect
L
of all available information in the market prices of the shares. In an
O
C
efficient capital market the prices of the shares are neither too low nor
/
too high but just rational and adjust instantly with the new information.
E
C
The efficient market hypothesis is based on the premise that the security
D
prices are an unbiased reflection of all the available information and that
©D
every new information travels in a random fashion. The security prices
reflect:
(i) All past information regarding the company and the security.
(ii) Information which has been announced not yet implemented.
(iii) Information which is not known to public but only available to
insiders.
The investor needs to find out the level of efficiency in the stock market
before making any investment. The kind of information immediately
PAGE 37
Notes reflected and the speed at which this information gets reflected in the
prices would determine the level of efficiency of the market. Based on
this, there are three forms of market efficiency: weak form, semi-strong
form and strong form of market efficiency.
2.7.1 Weak Form of Market Efficiency

In weak form of market efficiency all the historical information (past
data) has already been absorbed in the market prices and thus future
h i
e l
prices cannot be predicted using the past information. The weak form of
D
market efficiency is also known as Random Walk Theory, as the security
of
prices take a random walk as any new information randomly enters the
market. The future prices cannot be predicted using trend analysis. It
i t y
thus discards the utility of technical analysis.
2.7.2 Semi-strong Form of MarketsEfficiency

e r
i v
n
In this form of market efficiency the security prices reflect all the publicly
U
available information. This form of market efficiency provides that as soon
,
as the information is publicly available it gets absorbed in the prices. Such
O L
information may be with regard to financial statements or the merger/
acquisition or product line or regarding the management. The investor
/ S
buys or sells the shares based on the nature of the information and soon
L
the impact gets reflected in the market prices of the shares. In semi strong
O
C
form of market efficiency, as all the publicly available information is
E/
already reflected in the market prices, fundamental analysis is of new use
C
in determining the value of the shares. This form supports that as any
D
new information is available, all investors assess that information with
© D same speed and accuracy and no one is able to out-perform the market.
2.7.3 Strong Form of Market Efficiency

In this form of market efficiency the share prices reflect all the information
inclusive of the insider information and thus no one can make any
abnormal profits. The strong form of market efficiency lays that even the
privileged and the selected few insiders who have access to the inside
38 PAGE
information are not able to earn superior returns. Thus when the stock Notes
markets are efficient in their strong form, the security analysts and the
portfolio managers (having quick access to information) are also not able
to earn higher amount of profits.
Thus, the weak form of market efficiency is the lowest level, followed
by the semi strong form, which is higher than the weak form. The strong
form of market efficiency is of the highest among the three.
IN-TEXT QUESTIONS
h i
7. _____ A form of market efficiency shows that all publicly
e l
D
available information is reflected in the current market price.
of
(a) Strong form
(b) Semi-strong form
(c) Weak form
i ty
(d) None of the above
r s
v e
8. _____ form of market efficiency shows that all publicly and
n i
privately available information is reflected in the current market
U
price.
(a) Strong form
L ,
O
(c) Weak form
/ S
L
O
C
9. If the markets are inefficient, any new information received about
E
a security:
/
C
(a) No change in price
D
©D
(b) Negative demand for stock
(c) Price will fall first and later rise
(d) There will be lag in the adjustment of the price
10. Random walk hypothesis is most related to:
(a) Strong form
(c) Weak form
PAGE 39
Notes 2.8 Summary

Fundamental analysis is a systematic analysis of various determining
factors of the fair value of the share. It basically includes analysing
the economy, industry and the company.
It consists of two approaches: “Bottoms up approach” and “Top down
approach”.
i
Economic analysis is the study of the various forces operating in
the overall economy.
l h

D e
Industry analysis entails analysing the industry life cycle, labour
conditions, market conditions, stage of competition, government
of
policies regarding that industry, past performance of the industry,
ty
availability of raw material for that industry, level of technology
i
and its permanence etc.

r s
The company specific analysis is done with the objective of: (a)
v e
forecasting the earnings of the company (b) finding out the intrinsic
value of the share.
n i

, U
Book value of an equity share is the value of a firm’s ownership
divided by the number of outstanding equity shares.

O L
Liquidation Value method values equity shares based on the realisable
/ S
value of the asset minus the liabilities to be paid.

O L
As per dividend discount model of valuation, value of an equity
share is the sum of the present value of expected benefits from
/ Cholding of the equity share.
CE
As per earnings multiplier approach, the value of an equity share
D
is the earning per share multiplied with price to earnings ratio.
© D As per Gordon’s model, the value of equity share is given by:
P0 =
EPS 1 (1 − b)
k e − br
As per Walter’s model, P0 = D + r k e (E − D)

ke ke
The two basic strategies of investing are active and passive strategies.
Active strategy is to find stock and invest in individual stock.
Passive strategy is to invest in a market index.
40 PAGE
Technical analysis is the study of the past prices and trends using Notes
charts and patterns to forecast the future prices and movements.
Technical analysis uses various charts: bar chart, line chart, candle
stick charts, point and figure chart etc.
The common patterns studied are trend, head and shoulder, inverted
head and shoulder, triangle, double top and bottom etc.
The efficient market hypothesis is based on the premise that the
i
security prices are an unbiased reflection of all the available
information and that every new information travels in a random
l h

fashion.
In the weak form of market efficiency all the historical information
D e
of
(past data) has already been absorbed in the market prices and thus
future prices cannot be predicted using the past information. The
weak form of market efficiency is also known as Random Walk
i ty
s
Theory, as the security prices take a random walk as any new
r
e
information randomly enters the market.

i v
In semi-strong form of market efficiency the security prices reflect
all the publicly available information.
U n
,
The strong form of market efficiency lays that even the privileged and
O L
the selected few insiders who have access to the inside information
are not able to earn superior returns.
/ S
L
O
/ C
1. (a) Implicitly incorporates capital gain
C E
2. (b) Intrinsic value
D
3. (d) Move in trends
©D
4. (c) Both of these
5. (c) Any of these
6. (c) Price and volume
7. (b) Semi-strong form
a) Strong form
9. (d) there will be lag in the adjustment of the price
10. (c) Weak form
PAGE 41
Notes 2.10 Self-Assessment Questions

1. Briefly discuss the EIC framework.
2. What is the difference between fundamental analysis and technical
analysis?
3. State the assumptions of technical analysis.
4. Explain with example the support and resistance level.
5. Indicate the likely direction of change in the P/E ratio of a stock if
h i
l
the company increases its dividend pay-out ratio?
D e
6. Which stage of the industry life cycle is recommended for investment
of
and why?
7. Discuss the various strategies of investing in equity.
ty
:K\ GR LQWHUQDWLRQDO IDFWRUV DIIHFW WKH ,QGLDQ HFRQRP\"
s i
9. How is the stock market in India related to its economic activity?
e r
10. Discuss the various form of market efficiency?
i v
n
11. What are the implications of market efficiency for investors?
, U
7KH GLYLGHQG H[SHFWHG DW WKH HQG RI FXUUHQW \HDU LV ൗ DQG
the required rate of return appropriate for that risk class is 12%.
dividend model.
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Determine the current value of the equity share using the constant
/ S
L
7KH GLYLGHQG H[SHFWHG DW WKH HQG RI FXUUHQW \HDU LV ൗ DQG WKH
O
UHTXLUHGUDWHRIUHWXUQDSSURSULDWHIRUWKDWULVNFODVVLV'HWHUPLQH
C
the current value of the equity share if the dividend grows at a
/
CE
given constant rate of 2%.
'HWHUPLQHWKH3(UDWLRRI$%&/WG:KHQLWVPDUNHWSULFHLVൗ
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this risk class is 10%. Determine the value of an equity share if
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2.11 References
Fischer, D.E. & Jordan, R.J. Security Analysis & Portfolio Management,
(6th edition) Pearson Education.
42 PAGE
Sharpe, W.F., Alexander, G.J. & Bailey, J. Investments, (6th edition), Notes
Prentice Hall of India.
Frank K. Reilly & Keith C. Brown, (2012) Analysis of Investments
and Management of Portfolios (12th edition), Cengage India Pvt.
Ltd.
Chandra, P. (2017) Investment Analysis and Portfolio Management:
Tata McGraw Hill Education Private Limited.
h i
e l

D
Fischer, D.E. & Jordan, R.J. Security Analysis & Portfolio Management,
of
Pearson Education.
ty
Sharpe, W.F., Alexander, G.J. & Bailey, J. Investments, Prentice Hall
of India.
s i

e r
Frank K. Reilly & Keith C. Brown, (2012) Analysis of Investments
v
and Management of Portfolios Cengage India Pvt. Ltd.

n i
Chandra, P. Investment Analysis and Portfolio Management: Tata
McGraw Hill Education Private Limited.
, U
L
O
McGraw-Hill Education.

/ S
& Sons.
O L
/ C
E
Holden, C. W. (2014). Excel Modeling in Investments. England:
C
Pearson Education.

D
©D
5HLOO\).%URZQ.& /HHGV6- ,QYHVWPHQW$QDO\VLV
PAGE 43
L E S S O N
3
Fixed Income
Mr. Amit Kumar
Assistant Professor
University of Delhi
h i
STRUCTURE
e l
D
of
3.2 Introduction
3.3 Importance of Bond Valuation
i ty
3.4 Bond Pricing
r s
v e
3.6 Factors Affecting Bond Prices
n i
3.7 Bond Yields
, U
O L
S
3.9 Duration and Convexity
3.11 Passive Strategies ofL

/
3.10 Active Strategies of Fixed Income Investments
C O Fixed Income
3.12 Summary
/
3.13 Answers toEIn-Text Questions
D C Questions
3.14 Self-Assessment
© D
3.15 References

Define bond valuation and explain its significance in finance and investment.
Calculate the present value of future cash flows to determine the fair value of a bond.
Analyze the relationship between bond prices, interest rates, and yield to maturity.
Evaluate the risks associated with bond investments and strategies to manage them.
44 PAGE
FIXED INCOME
Compare and contrast different bond valuation models for various Notes
scenarios.
3.2 Introduction
3.2.1 Overview of Fixed Income Securities

Fixed income securities are financial instruments that represent a debt
h i
obligation issued by a borrower, such as a government, municipality, or
corporation, to raise capital. These securities are referred to as “fixed
e l
D
of
income” because they provide investors with a fixed or predetermined
stream of income in the form of periodic interest payments and the return
ty
of principal at maturity.
i
Fixed income securities include various types of bonds, notes, and other
s
r
debt instruments. They are typically characterized by the following key
e
v
features:
n i
1. Interest Payments: Fixed income securities pay regular interest
, U
payments to the bondholders at predetermined intervals, such as
semiannually or annually. The interest rate, also known as the
L
coupon rate, is usually fixed at the time of issuance.
O
/ S
2. Maturity Date: Fixed income securities have a specified maturity
L
date, which is the date on which the issuer is obligated to repay
O
the principal amount to the bondholders. Maturities can range from
C
/
short-term (less than a year) to long-term (up to several decades).
E
3. Principal or Face Value: The principal, also known as the face
C
D
value or par value, represents the initial investment amount that
©D
the issuer agrees to repay to the bondholders at maturity.
4. Credit Quality: Fixed income securities are assigned credit ratings
that reflect the creditworthiness of the issuer. Higher-rated securities
are considered less risky and typically offer lower yields, while
lower-rated securities carry higher risk but potentially offer higher
yields to compensate for the additional risk.
5. Market Price: The market price of fixed income securities can
fluctuate based on various factors such as changes in interest rates,
creditworthiness of the issuer, market demand, and overall economic
PAGE 45
Notes conditions. These price fluctuations impact the yield and potential
returns for investors.
Fixed income securities serve as important investment options for individuals,
institutional investors, and governments seeking a steady income stream
with relatively lower risk compared to other investment classes such as
equities. They provide diversification benefits and are often considered
a key component of a well-balanced investment portfolio.
i
Common types of fixed income securities include government bonds,
l
corporate bonds, municipal bonds, Treasury bills, Treasury notes, and
h
D e
mortgage-backed securities. Each type of security has its own characteristics,
risk profiles, and potential returns, offering investors a wide range of
of
choices to suit their investment objectives and risk tolerance.
3.3 Importance of Bond Valuation

i ty
r s
e
Bond valuation is the process of determining the fair value of a bond. It
is crucial for several reasons:
i v
U n
1. Pricing: Bond valuation allows investors to determine the fair
,
value or intrinsic value of a bond. This is important because it
O L
helps investors make informed decisions about whether a bond is
overpriced, underpriced, or fairly priced in the market. By comparing
/ S
the market price of a bond to its intrinsic value, investors can
L
identify potential opportunities for buying or selling bonds.
O
C
2. Investment Decision-Making: Bond valuation plays a vital role
E / in investment decision-making. It enables investors to assess the
C
attractiveness of different bonds based on their yields, risk profiles,
D
and potential returns. By valuing bonds, investors can compare
©D
them to alternative investment options and allocate their capital
efficiently.
3. Yield Calculation: Bond valuation is necessary for calculating the
yield of a bond accurately. Yield is a critical measure of return for
bond investors and helps determine the bond’s income potential.
By valuing the bond, investors can calculate metrics like Yield to
Maturity (YTM) or Yield to Call (YTC), which are essential in
assessing the bond’s profitability.
46 PAGE
FIXED INCOME
4. Risk Assessment: Bond valuation provides insights into the Notes

creditworthiness and default risk of a bond issuer. The valuation
process involves analyzing various factors such as interest rates,
credit ratings, and the issuer’s financial health. By valuing bonds,
investors can evaluate the risk associated with investing in a particular
bond and make informed decisions accordingly.
5. Portfolio Management: Bond valuation is crucial for managing
i
bond portfolios effectively. By valuing individual bonds, investors
can assess the overall risk and return characteristics of their bond
l h
e
holdings. This allows for diversification, duration management, and
the optimization of portfolio performance based on the investor’s
D
of
risk tolerance and investment objectives.
6. Trading and Arbitrage: Accurate bond valuation facilitates efficient
i ty
trading in the bond market. Traders can identify mispriced bonds
r s
by comparing their valuation to market prices and take advantage
e
of arbitrage opportunities. Proper bond valuation helps ensure fair
v
bond market.
n i
and transparent pricing, contributing to the overall efficiency of the
, U
In summary, bond valuation is essential for pricing bonds, making
O L
informed investment decisions, calculating yields, assessing risks, managing
portfolios, and facilitating efficient trading. It is a fundamental tool for
/ S
bond investors, traders, and market participants.
O L
C
3.4 Bond Pricing
E /
C
3.4.1 Bond Cash Flows
D
©D
In bond pricing, understanding the cash flows associated with a bond
is crucial. A bond represents a loan made by an investor to a borrower,
typically a government or corporation. The borrower agrees to make
periodic interest payments to the investor (bondholder) and repay the
principal amount at maturity. These cash flows can be divided into two
main components:
1. Coupon Payments: Bonds usually pay periodic interest payments,
known as coupon payments, to bondholders. The coupon rate is
PAGE 47
Notes the fixed annual interest rate specified by the bond. The coupon
payments are typically made semi-annually, although some bonds
may have different payment frequencies.
2. Principal Payment: At the bond’s maturity, the issuer repays the
bond’s face value, also called the principal or par value. This
represents the initial amount borrowed by the issuer.
Eg. - Suppose you have a bond with a face value (principal) of $1,000,
i
a coupon rate of 5% per annum, and a maturity period of 5 years. The
l
bond pays coupons annually. Therefore, you would receive $50 ($1,000
h
× 5%) in coupon payments each year for five years.
D e
of
The cash flows for this bond would look as follows:
Year 1: $50 (Coupon payment)
ty
s i
r
v e
n i
Year 5: $50 (Coupon payment) + $1,000 (Principal repayment)
, U
3.4.2 Time Value of Money and Discounting
O L
S
The time value of money is a fundamental concept in bond pricing. It
/
states that a dollar received in the future is worth less than a dollar
L
O
received today due to the opportunity cost of capital and inflation. To
C
account for the time value of money, future cash flows from a bond are
E /
discounted back to their present value using an appropriate discount rate.
D C Discounting involves applying a discount factor to each cash flow based

on the time it will take to receive that cash flow. The discount factor is
© D calculated using the discount rate, which is typically the yield required
by investors to hold a bond with similar characteristics. The discount
rate accounts for factors such as risk, market conditions, and interest
rate environment.
3.4.3 Present Value of Bond Cash Flows

The Present Value (PV) of bond cash flows refers to the current worth of
all expected future cash flows from a bond. It represents the fair value of
48 PAGE
FIXED INCOME
the bond in the market at a given point in time. To calculate the present Notes
value, each cash flow (coupon payments and principal) is discounted
individually using the appropriate discount rate.
The formula for calculating the present value of bond cash flows can be
expressed as:
PV = (C1/(1+r)^1) + (C2/(1+r)^2) + ... + (Cn/(1+r)^n) + (F/(1+r)^n)
Where:
PV = Present value of the bond
h i
C = Cash flow (coupon payment)
e l
r = Discount rate (yield)
D
F = Face value (principal)
of
ty
n = Number of periods (remaining years to maturity)
s i
Eg. - To calculate the present value of the bond’s cash flows, each future
e r
cash flow is discounted back to its present value. Let’s calculate the
present value of the cash flows for our example:
i v
Year 1: $50/(1 + 0.06)^1 = $47.17
U n
,
Year 2: $50/(1 + 0.06)^2 = $44.47
Year 3: $50/(1 + 0.06)^3 = $41.97
O L
S
Year 4: $50/(1 + 0.06)^4 = $39.66
L /
Year 5: ($50 + $1,000)/(1 + 0.06)^5 = $874.99
O
To find the bond’s price, we sum up the present values of all the cash
C
flows:
E /
C
Bond Price = $47.17 + $44.47 + $41.97 + $39.66 + $874.99 = $1,048.26
D D
Therefore, the bond’s price, considering a discount rate of 6%, would be
approximately $1,048.26.
©
The price of a bond and its yield have an inverse relationship. When
the yield on a bond increases, its price decreases, and vice versa. This
relationship can be explained by considering the coupon payments and
the discount rate:
PAGE 49
Notes 1. Coupon Payments: When the yield on a bond increases, the

coupon payments become less attractive relative to other investment
opportunities with higher yields. This reduces the demand for the
bond, leading to a decrease in its price.
2. Discount Rate: As the yield on a bond increases, the discount rate
used to calculate the present value of its cash flows also increases.
A higher discount rate lowers the present value of future cash flows,
i
resulting in a lower bond price.
l
Conversely, when the yield on a bond decreases, the bond becomes more
h
bond, driving its price higher.
D e
attractive compared to other investments. This increases demand for the
of
ty
3.6 Factors Affecting Bond Prices
s i
r
Several factors influence bond prices in addition to changes in yield.
e
Some key factors include:
i v
1. Interest Rates: Changes in general interest rates affect bond prices.
U n
When interest rates rise, bond prices fall, and vice versa. This
,
relationship is because new bonds with higher interest rates become
O L
available, making existing bonds with lower rates less attractive.
2. Credit Rating: The creditworthiness of the bond issuer affects bond
/ S
prices. If the issuer’s credit rating improves or deteriorates, the bond
L
price will be impacted accordingly. Higher credit ratings generally
O
C
lead to higher bond prices.
E /
3. Maturity: The time remaining until a bond’s maturity also affects
D C its price. Generally, longer-maturity bonds are more sensitive to

changes in interest rates, and their prices are more volatile compared
©D
to shorter-maturity bonds.
4. Market Sentiment: Investor sentiment and market conditions can
impact bond prices. Economic factors, geopolitical events, and
market trends can influence demand for bonds and, consequently,
their prices.
5. Call Provisions: Callable bonds give the issuer the option to redeem
the bonds before their maturity date. The presence of a call provision
50 PAGE
FIXED INCOME
can affect bond prices, as issuers may exercise this option when it Notes
becomes financially advantageous for them to do so.
3.7 Bond Yields

Bond yields represent the return an investor can expect to earn from a
bond investment. There are several different yield measures that provide
insights into different aspects of bond returns and are used for various
purposes. Let’s explore some common yield measures:
h i
e l
3.7.1 Coupon Yield
D
The coupon yield, also known as the nominal yield or the stated yield,
of
ty
represents the annual interest payment (coupon payment) of a bond
i
as a percentage of its face value (principal). It is calculated using the
s
following formula:
e r
i v
Coupon Yield = (Annual Coupon Payment/Face Value) × 100
U n
Example: Consider a bond with a face value of $1,000 and an annual
coupon payment of $60. The coupon yield can be calculated as follows:
L ,
Coupon Yield = (60/1,000) × 100
S O
Coupon Yield = 6%
L /
O
The coupon yield provides information about the fixed income generated
C
/
by a bond but does not consider changes in the bond’s price.
C E
3.7.2 Current Yield
D
©D
The current yield is a measure of the annual return on a bond based on
its current market price. It is calculated by dividing the annual coupon
payment by the bond’s market price and expressed as a percentage:
Current Yield = (Annual Coupon Payment/Current Market Price) × 100
Example: Suppose a bond has a face value of $1,000, an annual coupon
payment of $50, and a current market price of $950. The current yield
can be calculated as follows:
PAGE 51
Notes Current Yield = (Annual Coupon Payment/Current Market Price) × 100

Current Yield = (50/950) × 100
Current Yield = 5.26%
The current yield provides a more realistic measure of a bond’s return
since it considers the market price, which can vary from the bond’s face
value.
3.7.3 Yield to Maturity (YTM)

h i
e l
The yield to maturity represents the total return an investor will earn
D
of
if they hold the bond until its maturity date. YTM considers both the
annual coupon payments and the potential capital gain or loss if the bond
ty
is held to maturity.
s i
YTM is the discount rate that equates the present value of a bond’s cash
r
flows (coupon payments and principal) to its current market price. It
e
v
considers the time value of money and reflects the market’s expectations
about future interest rates.
n i
, U
Calculating YTM involves using trial and error or financial calculators,
spreadsheets, or specialized software. The YTM is expressed as an
O
annualized percentage.
L
/ S
Example: Let’s consider a bond with a face value of $1,000, an annual
O L
coupon payment of $60, a remaining term to maturity of 5 years, and a
current market price of $950. To calculate the YTM, we need to solve the
/ C
equation using trial and error or utilize financial calculators/spreadsheets:
C E$950 = ($60/(1 + YTM)^1) + ($60/(1 + YTM)^2) + ($60/(1 + YTM)^3)
D
+ ($60/(1 + YTM)^4) + ($1,060/(1 + YTM)^5)
©D
By iteratively trying different YTM values, we find that the YTM is
approximately 6.8%.
3.7.4 Yield Curve and Term Structure of Interest Rates

The yield curve is a graphical representation of the relationship between
the yields of bonds with different maturities. It shows the yields (or
interest rates) plotted against the bond’s time to maturity.
52 PAGE
FIXED INCOME
The shape of the yield curve provides insights into market expectations, Notes
economic conditions, and interest rate trends. A normal yield curve slopes
upward, indicating that longer-term bonds have higher yields than shorter-
term bonds. However, yield curves can also be flat, inverted, or humped,
reflecting different market conditions.
The term structure of interest rates refers to the pattern of interest rates
across different maturities. It provides a more detailed analysis of the
i
yield curve, capturing how yields change as bond maturities increase.
l h
D e
of
i ty
r s
v e
n i
, U
3.7.5 Understanding Yield Spreads
O L
/ S
Yield spreads refer to the difference in yields between different types of
L
bonds or between bonds with different credit ratings. They are indicators
O
C
of relative risk and can provide insights into market sentiment and
economic conditions.
E /
D C
For example, the yield spread between corporate bonds and government
bonds of similar maturities is often used to gauge the credit risk associated
©D
with corporate debt. A wider yield spread indicates higher perceived risk
for corporate bonds compared to government bonds.
Yield spreads can also be used to compare bonds with different credit
ratings. The spread between bonds with higher credit ratings (e.g., AAA-
rated) and lower credit ratings (e.g., BBB-rated) reflects the additional
yield investors require to hold riskier bonds.
PAGE 53
Notes Understanding yield spreads helps investors assess relative value and
make informed investment decisions based on their risk appetite and
market expectations.
It’s important to note that bond yields are subject to change due to various
factors, including interest rate movements, market conditions, credit
quality, and investor sentiment. Investors should carefully consider these
factors and conduct thorough analysis when evaluating bond investments.
h i
l
D e
Fixed income securities, such as bonds, come with various risks that
of
investors should consider when making investment decisions. Understanding
and managing these risks is crucial for assessing the potential returns and
ty
protecting one’s investment. Let’s explore some key risks associated with
fixed income securities:
s i
e r
3.8.1 Interest Rate Risk
i v
U n
Interest rate risk refers to the potential for changes in interest rates to
L ,
impact the value of fixed income securities. When interest rates rise,
bond prices tend to fall, and vice versa. This is because the fixed coupon
S O
payments of existing bonds become less attractive compared to newly
L /
issued bonds with higher coupon rates.
O
Example: Suppose you hold a 10-year bond with a fixed 5% coupon
C
/
rate. If interest rates rise to 6%, new bonds will be issued with a 6%
C Ecoupon rate, making your 5% coupon rate less competitive. As a result,

the value of your bond may decline.
D
©D
Mitigation: To manage interest rate risk, investors can consider diversifying
their fixed income holdings by investing in bonds with different maturities
and adjusting their portfolio’s duration based on their risk tolerance and
market expectations.
3.8.2 Credit Risk

Credit risk refers to the risk of the issuer defaulting on its payment
obligations. It is particularly relevant for bonds issued by entities with
54 PAGE
FIXED INCOME
lower credit ratings or those facing financial distress. A higher credit risk Notes
generally translates into higher yields to compensate investors for taking
on the additional risk.
Example: If a company’s credit rating is downgraded due to deteriorating
financial performance, the market may perceive it as having a higher
likelihood of default. As a result, the price of the company’s bonds may
decline.
i
Mitigation: Investors can manage credit risk by diversifying their bond
holdings across different issuers and considering bonds with higher credit
l h
ratings or investing in bond funds that provide exposure to a broader
range of issuers.
D e
of
ty
3.8.3 Default Risk
s i
r
Default risk specifically relates to the possibility of an issuer failing
e
to make timely interest payments or repaying the principal amount at
i v
maturity. Default risk can vary depending on the creditworthiness of the
issuer and prevailing economic conditions.
U n
,
Example: If a government or corporate entity is unable to meet its debt
bondholders.
O L
obligations, it may default on its bonds, leading to significant losses for
/ S
Mitigation: Investors can assess default risk by analyzing credit ratings
L
assigned by reputable credit rating agencies. Diversification and conducting
O
C
thorough research on issuers and their financial health can also help
E
manage default risk.
/
D C
3.8.4 Reinvestment Risk
©D
Reinvestment risk refers to the potential for future cash flows from a
fixed income security to be reinvested at lower interest rates. This risk
can affect the overall return on a bond investment, especially when
interest rates decline.
Example: If you own a bond with a fixed coupon rate and interest rates
decrease, the reinvestment of future coupon payments or the principal
repayment at maturity may yield lower returns.
PAGE 55
Notes Mitigation: Investors can manage reinvestment risk by considering bonds

with lower coupon rates, shorter maturities, or by using zero coupon
bonds or by implementing laddered bond portfolios to stagger maturities
and potentially capture higher rates in the future.
3.8.5 Call Risk

Call risk arises when a bond issuer exercises its right to redeem a bond
h
before its scheduled maturity date. Callable bonds give the issuer the
i
e l
option to repay the bond earlier, typically when interest rates have fallen,
D
enabling them to refinance at a lower cost.
of
Example: If you hold a callable bond and interest rates decline, the
issuer may decide to call the bond, forcing you to reinvest the principal
ty
at lower rates.
s i
r
Mitigation: Investors can evaluate the call provisions and potential
e
call risk associated with bonds before investing. Bonds with longer call
i v
protection periods or higher call premiums may offer more protection
against call risk.
U n
L
3.8.6 Liquidity Risk ,
S O
/
Liquidity risk refers to the ease with which an investor can buy or sell
L
a fixed income security without significantly impacting its price. Illiquid
O
bonds may have wider bid-ask spreads, making it difficult to buy or sell
C
/
at desired prices.
C EExample: If you own a bond that has low trading volume and limited
D
market participants, it may be challenging to sell the bond quickly,
©D
potentially resulting in a lower sale price.
Mitigation: Investors can manage liquidity risk by investing in bonds with
higher trading volumes, actively monitoring market liquidity conditions,
and considering diversification across different types of fixed income
securities.
3.8.7 Exchange Rate Risk

Exchange rate risk applies to fixed income securities denominated in
56 PAGE
FIXED INCOME
foreign currencies. Fluctuations in exchange rates can impact the returns Notes
for investors who hold bonds issued in foreign currencies.
Example: If you hold a bond denominated in a foreign currency and the
value of that currency depreciates against your home currency, the bond’s
returns when converted back into your home currency may be reduced.
Mitigation: Investors can manage exchange rate risk by hedging their
currency exposure using derivatives or by investing in bond funds that
i
offer currency-hedged strategies.
l h
3.8.8 Inflation Risk
D e
of
Inflation risk refers to the potential for inflation to erode the purchasing
power of fixed income returns. When inflation rises, the real value of
fixed coupon payments and principal decreases.
i ty
r s
Example: If you hold a bond with a fixed coupon rate, but inflation
e
increases, the purchasing power of the fixed coupon payments may
v
decline, resulting in lower real returns.
n i
U
Mitigation: Investors can consider inflation-protected securities, such as
L ,
Treasury Inflation-Protected Securities (TIPS) and Inflation Indexed Bonds
(IIB), which provide returns linked to inflation, helping to mitigate the
impact of inflation risk.
S O
L /
O
3.8.9 Assessing and Managing Risks
/ C
To assess and manage risks associated with fixed income securities,
C E
investors should:
D
- Conduct thorough research on issuers, including their creditworthiness,
©D
financial health, and industry trends.
- Diversify their bond holdings across different issuers, sectors, and
geographies to spread risk.
- Stay informed about market conditions, economic indicators, and
central bank policies that may impact interest rates and credit
markets.
- Regularly review and rebalance their fixed income portfolio based
on changing risk profiles and investment goals.
PAGE 57
Notes - Consider working with a financial advisor who can provide guidance
and expertise in navigating fixed income risks.
By understanding these risks and implementing appropriate risk management
strategies, investors can make informed decisions when investing in fixed
income securities.
3.9 Duration and Convexity
h i
3.9.1 Duration
e l
D
of
Bond duration is a fundamental concept in fixed income investing that
measures the sensitivity of a bond’s price to changes in interest rates.
ty
It provides investors with an understanding of how much the price of
i
a bond is likely to change in response to fluctuations in interest rates.
s
e r
Duration is expressed in years and helps investors estimate the percentage
i v
change in a bond’s price for a given change in interest rates. It is a useful
n
tool for assessing interest rate risk and comparing the price sensitivity
of different bonds.
, U
L
The concept of bond duration is based on two key factors: the timing
O
of a bond’s cash flows and the present value of those cash flows. The
/ S
duration calculation takes into account the timing and weighting of each
L
cash flow to determine the bond’s weighted average time to receive its
O
cash flows.
C
E /
The formula for bond duration is as follows:
C
Duration = [¦(t×PV CFt)/PV]
D Where:
©D
- t represents the time period until each cash flow is received,
- PV CFt represents present value of the cash flow at time period t,
- PV represents the present value of the bond’s future cash flows.
To calculate bond duration, one must determine the present value of each
cash flow and then calculate the weighted average of the time periods
based on the present value of each cash flow.
58 PAGE
FIXED INCOME
Let’s consider an example to illustrate the concept of bond duration. Notes

Assume you are considering two bonds: Bond A and Bond B.
Bond A has a face value of $1,000, a coupon rate of 5% (paid annually),
and a maturity of 5 years. The current yield-to-maturity (YTM) is 4%.
Bond B has a face value of $1,000, a coupon rate of 3% (paid semi-
annually), and a maturity of 10 years. The current yield-to-maturity
(YTM) is 6%.
To calculate the duration of each bond, we need to determine the present
h i
value of each cash flow and the weighted average of their time periods.
e l
For Bond A:
D
of
Period 1:
ty
Coupon Payment: $1,000 × 0.05 = $50
PV = $50/(1 + 0.04) = $48.08
s i
Period 2:
e r
Coupon Payment: $50
i v
PV = $50/(1 + 0.04)^2 = $46.30
U n
Period 3:
L ,
O
Coupon Payment: $50
PV = $50/(1 + 0.04)^3 = $44.66
/ S
Period 4:
O L
C
Coupon Payment: $50
E /
PV = $50/(1 + 0.04)^4 = $43.15
Period 5:
D C
©D
Coupon Payment: $50 + $1,000 (principal)
PV = ($50 + $1,000)/(1 + 0.04)^5 = $1,038.74
Using the formula, we can calculate the weighted average of the time
periods:
Duration of Bond A = [(1 × 48.08) + (2 × 46.30) + (3 × 44.66) + (4 ×
43.15) + (5 × 1,038.74)]/$1,220.93
Duration of Bond A = 4.48
PAGE 59
Notes For Bond B:

Period 1:
Coupon Payment: $1,000 × 0.03/2 = $15
PV = $15/(1 + 0.06/2) = $14.15
Period 2:
Coupon Payment: $15
PV = $15/(1 + 0.06/2)^2 = $13.35
h i
Period 19:
e l
D
Coupon Payment: $15
of
PV = $15/(1 + 0.06/2)^19 = $8.70
ty
Period 20:
Coupon Payment: $15 + $1,000 (principal)
s i
r
PV = ($15 + $1,000)/(1 + 0.06/2)^20 = $967.84
e
i v
Using the formula, we can calculate the weighted average of the time
periods:
U n
Duration of Bond B = [(0.5 × 14.15) + (1 × 13.35) + ... + (19.5 × 8.70) +
L
(20 × 967.84)]/$1,220.93 ,
O
Duration of Bond B = 7.54
S
L /
In this example, we can see that Bond B has a longer duration of 7.54
O
compared to Bond A, which has a duration of 4.48. This means that Bond
C
B is more sensitive to changes in interest rates than Bond A.
E /
For example, if interest rates increase by 1%, we can estimate the
D C approximate percentage change in bond prices using their respective

durations. Using the formula:
©D
Percentage Change in Bond Price | ±'XUDWLRQ îǻ<70
For Bond A:
Percentage Change in Bond A Price | (–4.48 × 0.01) =
–0.0448 or –4.48%
For Bond B:
Percentage Change in Bond B Price | (–7.54 × 0.01) = –0.0754 or –7.54%
60 PAGE
FIXED INCOME
Based on these calculations, we can expect Bond B to experience a larger Notes

percentage decrease in price compared to Bond A for a 1% increase in
interest rates.
This example demonstrates how bond duration provides insights into the
price sensitivity of different bonds to changes in interest rates, allowing
investors to make informed decisions based on their risk tolerance and
investment objectives.
i
Bond duration provides investors with several important insights:
1. Interest Rate Sensitivity: Duration quantifies a bond’s sensitivity to
l h
changes in interest rates. The higher the duration, the more sensitive
D e
of
the bond’s price is to interest rate changes. Bonds with longer
maturities and lower coupon rates generally have higher durations
ty
because their cash flows are received further in the future.
i
2. Price Volatility: Duration helps estimate the potential price volatility
s
r
of a bond. If interest rates rise, the price of a bond with a higher
e
v
duration is likely to decline more than a bond with a lower duration.
n i
Conversely, if interest rates decrease, the price of a bond with a
U
higher duration is likely to increase more.
L ,
3. Duration Matching: Duration can be used to match the duration
of a bond portfolio to an investor’s desired investment horizon or
S O
liability stream. By aligning the duration of the portfolio with the
L /
time horizon, investors can minimize the impact of interest rate
O
fluctuations.
/ C
It’s important to note that bond duration has some limitations. First,
E
duration assumes a linear relationship between interest rates and bond
D C
prices, which may not hold true for large interest rate changes. Second,
duration does not account for other factors such as credit risk, changes
©D
in portfolio due to maturity of some bonds and changes in interest rates
or call provisions.
3.9.2 Convexity
Bond convexity is a measure of the curvature of the relationship between
a bond’s price and changes in interest rates. It provides additional
information beyond bond duration, offering a more accurate estimate of
how a bond’s price will change in response to interest rate fluctuations.
PAGE 61
Notes Convexity accounts for the fact that the relationship between bond prices
and interest rates is not linear. As interest rates change, the percentage
change in bond prices is not proportional to the change in interest rates.
Convexity captures the non-linear behavior by quantifying the curvature
of the price-yield relationship.
A positive convexity indicates that as interest rates change, bond prices
will change by a greater percentage than what duration alone predicts. In
i
other words, a bond with positive convexity will experience smaller price
l h
declines for a given increase in interest rates and larger price increases
e
for a given decrease in interest rates.
D
Conversely, a negative convexity implies that bond prices will change
of
by a smaller percentage than what duration alone suggests. Bonds with
negative convexity, such as callable bonds, may experience larger price
declines when interest rates increase.
i ty
r s
Understanding bond convexity is crucial for investors as it helps refine
e
the estimates provided by bond duration and provides insights into the
v
i
potential risks and rewards associated with changes in interest rates. It
n
U
allows investors to better manage their bond portfolios and make more
,
informed investment decisions.
O L
/ S
O L
/ C
C E
D
©D
3.10 Active Strategies of Fixed Income Investments
Fixed income investors have the option to pursue active strategies to
enhance returns and manage risks. Active management involves making
62 PAGE
FIXED INCOME
strategic investment decisions based on market analysis and research. Let’s Notes
explore some common active strategies used in fixed income investments:
3.10.1 Active Management vs. Passive Management

Active management involves actively selecting and managing a portfolio
of fixed income securities with the aim of outperforming a benchmark or
generating superior risk-adjusted returns. This approach requires ongoing
research, analysis, and decision-making by portfolio managers.
h i
Passive management, on the other hand, involves replicating the performance
e l
of a specific fixed income index or benchmark through the use of index
D
of
funds or exchange-traded funds (ETFs). Passive strategies aim to match
the performance of the benchmark rather than outperform it.
i ty
Active management allows for flexibility in security selection, duration
r s
management, and sector allocation, giving portfolio managers the
e
opportunity to respond to changing market conditions and potentially
generate excess returns.
i v
U n
,
3.10.2 Credit Analysis and Bond Selection
O L
Active fixed income managers conduct thorough credit analysis to assess
/ S
the creditworthiness of issuers and make informed decisions about bond
L
selection. They evaluate factors such as the issuer’s financial health, debt
O
structure, industry trends, and credit ratings.
C
E /
By actively selecting bonds with attractive risk-return profiles, managers
aim to enhance portfolio performance and manage credit risk. This
D C
involves seeking bonds with higher yields relative to their credit quality or
©DDuration Management
identifying undervalued bonds with the potential for credit rating upgrades.
3.10.3
Duration is a measure of a fixed income security’s sensitivity to changes
in interest rates. Active fixed income managers actively manage the
duration of their portfolios to capitalize on interest rate expectations and
yield curve movements.
PAGE 63
Notes If managers anticipate interest rates to rise, they may reduce portfolio
duration by shortening bond maturities or investing in floating-rate
securities. Conversely, if rates are expected to decline, they may increase
duration to capture potential capital gains.
Duration management allows managers to control interest rate risk and
potentially enhance returns by positioning the portfolio based on interest
rate forecasts.
h i
l
3.10.4 Yield Curve Strategies
D e
Yield curve strategies involve taking positions along the yield curve to
of
benefit from changes in the shape or level of the curve. Active managers
may employ strategies such as:
i ty
- Yield curve steepening: Positioning the portfolio to benefit from
r s
an increase in the spread between short-term and long-term interest
e
rates. This can be achieved by increasing exposure to longer-dated
bonds.
i v
U n
- Yield curve flattening: Positioning the portfolio to benefit from a
,
decrease in the spread between short-term and long-term interest
bonds.
O L
rates. This can be achieved by increasing exposure to shorter-dated
/ S
- Riding the yield curve: Concentrating investments in bonds with
L
maturities that align with the expected movement in interest rates.
O
C
For example, if interest rates are expected to decline, investing in
E / longer-dated bonds can capture capital gains as their prices rise.
D C These strategies require active monitoring of interest rate expectations,

economic indicators, and central bank policies to make informed positioning
©D
decisions along the yield curve.
3.10.5 Sector Rotation

Sector rotation involves actively allocating investments across different
sectors within the fixed income market based on economic and market
conditions. Active managers assess factors such as sector fundamentals,
credit spreads, and interest rate trends to identify sectors that may
outperform or underperform.
64 PAGE
FIXED INCOME
For example, if managers believe that the financial sector will outperform Notes
due to favorable economic conditions, they may increase exposure to
financial bonds. Conversely, if they anticipate headwinds for the energy
sector, they may reduce or avoid exposure to energy-related bonds.
Sector rotation allows managers to take advantage of relative value
opportunities and adjust portfolio allocations based on changing market
dynamics.
h i
l
3.10.6 Convexity and Callable Bonds
Convexity refers to the relationship between bond prices and changes
D e
of
in interest rates. Callable bonds, which give issuers the right to redeem
bonds before maturity, exhibit convexity.
i
Active fixed income managers analyze the convexity characteristics of
ty
r s
callable bonds and consider the potential impact on portfolio returns.
e
They evaluate factors such as the bond’s yield, call date, call premium,
and potential reinvestment opportunities.
i v
U n
Managers may seek callable bonds with favorable convexity profiles,
,
which can offer potential if interest rates decline and the issuer does not
call the bonds.
O L
By actively managing the convexity exposure of their portfolios, managers
/ S
aim to enhance risk-adjusted returns and protect against potential losses
L
resulting from interest rate movements.
O
Conclusion:
/ C
C E
Active strategies in fixed income investments offer opportunities for
investors to outperform benchmarks, manage risks, and capitalize on
D
market conditions. Active managers employ various strategies such as
©D
credit analysis, duration management, yield curve strategies, sector rotation,
and convexity management.
However, active management requires diligent research, monitoring, and
decision-making to identify attractive investment opportunities and adjust
portfolios accordingly. Investors should carefully consider their risk tolerance,
investment objectives, and the expertise of the portfolio managers when
deciding between active and passive fixed income strategies.
PAGE 65
Notes 3.11 Passive Strategies of Fixed Income

Passive strategies in fixed income investments aim to replicate the
performance of a specific bond index or benchmark. These strategies
offer a more hands-off approach to investing, focusing on broad market
exposure and minimizing transaction costs. Let’s explore some common
passive strategies used in fixed income investments:
3.11.1 Indexing and Bond ETFs

h i
e l
D
Indexing involves investing in a portfolio of bonds that mirrors the
of
composition and weightings of a specific bond index, such as the S&P
BSE India Bond Index Barclays U.S. Aggregate Bond Index or the
ty
Bloomberg Barclays Global Aggregate Index. The goal is to closely track
the performance of the chosen index.
s i
r
Passive fixed income investors can achieve index exposure through bond
e
v
exchange-traded funds (ETFs). Bond ETFs trade on stock exchanges and
n i
provide investors with diversification across a broad range of bonds in
U
a single investment vehicle.
L ,
By investing in bond ETFs or index funds, investors can gain access to
O
a diversified portfolio of bonds without the need for individual security
S
selection. This passive approach provides exposure to the overall
L /
performance of the bond market.
C O
/
3.11.2 Bond Laddering
C EBond laddering is a passive strategy that involves building a portfolio
D of bonds with staggered maturities. The portfolio consists of bonds with
©D
different maturity dates, such as 1 year, 3 years, 5 years, and so on.
With a bond ladder, as each bond matures, the proceeds can be reinvested
in new bonds at the longest end of the ladder. This approach ensures a
consistent cash flow stream while reducing the impact of interest rate
fluctuations.
Bond laddering is a passive strategy because the portfolio is constructed
with a predefined structure and requires less active management. It
66 PAGE
FIXED INCOME
provides investors with a disciplined approach to managing interest rate Notes

risk and cash flow needs.
3.11.3 Buy-and-Hold Strategy

The buy-and-hold strategy is a passive approach where investors purchase
bonds with the intention of holding them until maturity. This strategy
focuses on earning the stated coupon payments and principal repayment
at maturity, rather than actively trading or timing the market.
h i
The buy-and-hold strategy benefits from the fixed income securities’
e l
predictable cash flows and avoids transaction costs and the need for
D
of
constant portfolio adjustments. It is suitable for investors with a long-
term investment horizon and a desire for stability and income generation.
i ty
3.11.4 Immunization and Dedication
r s
v e
i
Immunization and dedication strategies aim to match the cash flow needs
n
of investors with the cash flows generated by fixed income securities.
U
Immunization involves constructing a portfolio of bonds that generates
,
L
sufficient cash flows to meet future liabilities, such as retirement expenses
O
or pension payments. By aligning the duration and cash flows of the
/ S
portfolio with the investor’s time horizon, immunization minimizes the
L
impact of interest rate fluctuations.
O
Dedication is a similar strategy that matches the duration and cash flows
C
E /
of the bond portfolio to a specific liability stream, such as the payments
needed to fund a bond’s principal and interest payments.
D C
Both immunization and dedication are passive strategies that focus on
©D
cash flow matching and reducing interest rate risk. These strategies are
commonly used by institutional investors and pension funds to meet their
long-term obligations.
3.11.5 Risk-Return Trade-offs in Passive Strategies

Passive strategies in fixed income investments generally offer lower costs
and lower portfolio turnover compared to active strategies. However,
PAGE 67
Notes they may also result in lower potential returns and limited flexibility in
responding to changing market conditions.
Investors pursuing passive strategies should consider the following risk-
return trade-offs:
- Lower Costs: Passive strategies typically have lower expense ratios
and lower trading costs compared to active strategies, which can
improve overall returns.
- Market Risk: Passive strategies expose investors to market risk
h i
l
since the portfolio performance closely tracks the performance of
e
D
the chosen index or benchmark. If the overall market experiences
of
losses or volatility, passive portfolios will reflect those changes.
- Limited Flexibility: Passive strategies often lack the flexibility to
ty
adjust holdings based on individual security analysis or market
s i
conditions. They are designed to replicate the index composition,
r
which may not align with specific investment objectives or market
e
v
opportunities.
n i
- Income Generation: Passive strategies focused on broad market
, U
exposure may provide relatively stable income generation, but they
may not maximize income potential compared to active strategies
O L
that actively seek higher-yielding bonds or sectors.
/ S
- Interest Rate Risk: Passive strategies that replicate a bond index
O L
will be exposed to interest rate risk. If interest rates rise, bond
prices will typically decline, potentially resulting in capital losses
/ C
for passive portfolios.
C EConclusion:
D
Passive strategies in fixed income investments provide investors with a
©D
more hands-off approach, focusing on replicating the performance of a
specific bond index or benchmark. These strategies include indexing through
bond ETFs, bond laddering, buy-and-hold strategies, and immunization/
dedication.
While passive strategies offer benefits such as lower costs and reduced
transaction activity, investors should be aware of the potential limitations,
including limited flexibility, exposure to market risk, and potential lower
returns compared to active strategies. It’s important to align passive
68 PAGE
FIXED INCOME
strategies with individual investment objectives, risk tolerance, and time Notes
horizon.
IN-TEXT QUESTIONS
1. Calculate the current yield for a bond with a face value of $1,200,
an annual coupon payment of $60, and a current market price
of $1,150.
(a) 5.22%
(b) 4.35%
h i
(c) 7.12%
e l
(d) 6.52%
D
of
2. A bond has a duration of 7.8 years. If interest rates increase by
ty
1%, what is the approximate percentage change in the bond’s
price?
s i
(a) –7.8%
e r
(b) –1.56%
i v
(c) –7.08%
U n
,
(d) –0.78%
L
3. Consider a bond with a face value of $1,000, a coupon rate of
O
S
4% paid semi-annually, and a current market price of $950.
L /
What is the bond’s yield to maturity (YTM)?
(a) 4.42%
C O
(b) 2.74%
E /
C
(c) 3.62%
D
(d) 5.05%
©D
4. What is the primary function of bond duration in fixed income
investing?
(a) Measure of bond’s face value
(b) Sensitivity to changes in interest rates
(c) Indicator of credit risk
(d) Coupon payment calculation
PAGE 69
Notes 5. Which risk refers to the potential for future cash flows from a
fixed income security to be reinvested at lower interest rates?
(a) Credit Risk
(b) Reinvestment Risk
(c) Call Risk
(d) Liquidity Risk
i
6. What does yield to maturity (YTM) represent for a bond investor?
(a) Total return until maturity
l h
(b) Annual coupon payment
D e
of
(c) Current market price
(d) Capital gain at maturity
i ty
7. What does the yield curve indicate about the relationship between
bond yields and maturities?
r s
v e
(a) It shows bond prices against time
n i
(b) It shows the relationship between coupon rates and face
U
values
,
(c) It illustrates the relationship between yields and maturities
L
O
(d) It represents the correlation between credit ratings and
/ S
bond prices
O L
8. Which strategy involves actively allocating investment sacross
different sectors within the fixed income market?
/ C (a) Yield Curve Strategies
CE
(b) Sector Rotation
D D (c) Bond Laddering
©
(d) Buy-and-Hold Strategy
9. What is the primary goal of bond laddering in fixed income
investments?
(a) Maximizing capital gains
(b) Minimizing credit risk
(c) Achieving consistent cash flow
(d) Reducing duration risk
70 PAGE
FIXED INCOME
10. What is the main advantage of passive fixed income strategies? Notes
(a) Higher potential returns

(b) Lower transaction costs
(c) Greater flexibility in security selection
(d) Active management of duration
3.12 Summary
h i
Fixed income securities are financial instruments issued by a borrower
e l
to raise capital, providing investors with a steady income stream
D
of
through periodic interest payments and principal return at maturity.
Key features include fixed interest payments, maturity dates, principal
or face value, credit quality, and market price fluctuations.
i ty

r s
Common types include government bonds, corporate bonds, municipal
e
bonds, Treasury bills, notes, and mortgage-backed securities. Bond
v
n i
valuation is crucial for pricing, investment decision-making, capital
allocation, risk assessment, portfolio management, trading, and
arbitrage.
, U

O L
The Present Value (PV) of bond cash flows represents the fair value
of a bond at a given point in time. Factors affecting bond prices
/ S
include interest rates, credit ratings, maturity, market sentiment,
L
call provisions, and bond yields.
O
C
/

100
C E
Current Yield = (Annual Coupon Payment/Current Market Price) ×
D
©D
The yield to maturity represents the total return an investor will
earn if they hold the bond until its maturity date. YTM considers
both the annual coupon payments and the potential capital gain or
loss if the bond is held to maturity.
Fixed income securities, such as bonds, face various risks that investors
must consider when making investment decisions. These risks
include interest rate, credit, reinvestment, call, liquidity, exchange
rate, inflation, and bond duration. To manage these risks, investors
PAGE 71
Notes should diversify their holdings, consider higher credit ratings, and
invest in bond funds with a wider range of issuers.
Bond duration measures the sensitivity of a bond’s price to changes
in interest rates, providing insights into interest rate sensitivity, price
volatility, duration matching, and yield-to-maturity estimation.
'XUDWLRQ > W î 39 &)W 39@
Where:
- t represents the time period until each cash flow is received,
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- CFt represents the cash flow at time period t,
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- PV represents the present value of the bond’s future cash flows.

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Bond convexity measures the relationship between bond prices
s i
and interest rate fluctuations, providing accurate estimates.
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Understanding convexity helps investors make informed
e
v
investment decisions.

n i
Active management involves selecting and managing portfolios
U
of fixed income securities to outperform benchmarks and
,
L
generate superior risk-adjusted returns. Active managers
O
conduct credit analysis, bond selection, duration management,
S
and sector allocation to respond to changing market conditions
L /
and generate excess returns.
CO
Passive strategies, like indexing and bond ETFs, replicate
/
bond index performance, provide broad market exposure, and
C E minimize transaction costs. Bond laddering, buy-and-hold, and

immunization and dedication strategies are common in fixed
D D income investments. These strategies offer lower costs and
©
portfolio turnover, but may result in lower potential returns
and limited flexibility.
1. (a) 5.22%
2. (a) –7.8%
3. (a) 4.42%
72 PAGE
FIXED INCOME
4. (b) Sensitivity to changes in interest rates Notes

5. (b) Reinvestment Risk
6. (a) Total return until maturity
7. (c) It illustrates the relationship between yields and maturities
8. (b) Sector Rotation
9. (c) Achieving consistent cash flow
10. (b) Lower transaction costs
h i
e l
D
1. What is bond valuation? How is it carried out in practice?
of
ty
2. Calculate the present value of the bond’s cash flows with a 7%
s
annual coupon (par value of $100) that matures in 4 years.
i
e r
3. Describe the various types of bond yields and how to calculate them.
i v
4. What are the risks involved in fixed income investing?
U
5. Describe duration and convexity of a bond.
n
L ,
6. Suppose a 15-year bond with an annual coupon of 7% is currently
trading at $98,550. The bond has a duration of 3.28. Compute and
S O
interpret the bond’s duration for a 25 basis point decrease in all
rates.
L /
O
7. Contrast active and passive investment strategies for fixed income.
3.15 References/ C
C E

D
Veronesi, P. (2010). Fixed income securities: Valuation, risk, and
©D
risk management. John Wiley & Sons.
Fabozzi, F. J., & Mann, S. V. (2014). Fixed income analysis. Wiley
Finance.
Gibson, R. L. (2013). Fixed income securities: A practical approach
(6th ed.). CFA Institute Investment Series.
Sundaresan, S. (2010). Fixed income markets and their derivatives.
Academic Press.
PAGE 73
L E S S O N
4
Alternative Investments
Mr. Amit Kumar
Assistant Professor
University of Delhi
h i
STRUCTURE
e l
D
of
4.2 Introduction
4.3 Real Estate Investments
i ty
4.4 Commodities Investing
r s
4.5 Derivative Instruments
v e
4.6 Other Alternative Asset Classes
n i
4.7 Summary
, U
O L
S
4.10 References
L /
C O
/

C E
Understand the principles and benefits of real estate investing.
D
Explain the role and significance of derivatives in financial markets.
©D

Evaluate the risks and rewards associated with commodities as an alternative asset
class.
Analyze the characteristics and strategies of alternative asset classes like cryptocurrency,
P2P lending, hedge funds, and private equity.
Compare and contrast the various alternative investment options discussed, considering
their suitability for different investment objectives.
74 PAGE
ALTERNATIVE INVESTMENTS
4.2 Introduction Notes
In addition to traditional investment options like stocks and bonds, there is

a wide range of alternative investment alternatives available to investors.
This section will explore the importance of diversification, provide an
overview of different investment alternatives, and discuss the benefits
and risks associated with investing in alternative assets.
4.2.1 Importance of Diversification

h i
e l
D
Diversification is a fundamental principle in investing that involves
of
spreading investment capital across a variety of assets to reduce risk
and potentially enhance returns. It is based on the premise that different
ty
investments perform differently under varying market conditions. By
i
diversifying, investors aim to achieve a balance between risk and return.
s
r
There are several key reasons why diversification is important in investment
e
v
portfolios:
n i
1. Risk Reduction: Diversification helps mitigate the impact of market
U
volatility on a portfolio. Different asset classes have varying levels
,
L
of risk, and their performances can be influenced by different factors.
O
When one asset class experiences a downturn, other asset classes
S
may perform better, thereby offsetting losses. By diversifying across
L /
different investments, such as stocks, bonds, real estate, commodities,
O
and alternative assets, investors can potentially minimize the risk
/ C
associated with any single investment.
C E
2. Smoothing Out Returns: Diversification can help smooth out
investment returns over time. Different assets and sectors can
D
©D
experience different cycles of growth and decline. By having a
mix of investments, gains from some assets may offset losses from
others, resulting in a more consistent overall return pattern. This
can provide a more stable investment experience and reduce the
impact of short-term market fluctuations.
3. Capital Preservation: Diversification helps protect against catastrophic
losses. By avoiding over-concentration in a single investment or
sector, investors reduce the risk of significant capital erosion if a
particular asset or industry experiences a severe decline. Diversification
PAGE 75
Notes spreads risk and helps preserve capital by not relying too heavily
on the performance of any one investment.
4. Exposure to Different Opportunities: Diversification allows investors
to participate in different investment opportunities and asset classes.
Various asset classes have unique risk and return profiles, responding
differently to economic conditions, industry trends, and geopolitical
events. By diversifying, investors can access a broader range of
i
investment possibilities, potentially benefiting from opportunities
in different markets and sectors.
l h
D e
5. Behavioral Benefits: Diversification can help investors manage
their emotions and avoid impulsive investment decisions. Holding a
of
diversified portfolio can reduce the urge to make drastic changes in
response to short-term market fluctuations. It provides a disciplined
i ty
approach to investing and helps investors stay focused on long-term
r s
goals by reducing the impact of individual investment performance.
e
It is important to note that diversification does not guarantee profits or
v
i
protect against losses. It is not a foolproof strategy that can eliminate all
n
U
investment risks. However, it is widely recognized as a prudent approach
,
to managing risk and potentially enhancing long-term investment outcomes.
L
To effectively diversify a portfolio, investors should consider a mix of
O
S
asset classes, industries, geographic regions, and investment strategies.
/
The specific allocation will depend on individual goals, risk tolerance,
L
O
and time horizon. Regular monitoring and periodic rebalancing may be
C
necessary to maintain the desired diversification level as market conditions
/
E4.2.2 Overview of Different Investment Alternatives
and investment performance evolve.
D C
©D Alternative investment alternatives are those that fall outside the traditional
asset classes of stocks, bonds, and cash. They offer investors a broader
range of options to allocate their capital and potentially generate returns.
Some common alternative investment alternatives include real estate,
commodities, derivatives, private equity, hedge funds, cryptocurrencies,
art, and collectibles:
1. Real Estate: Real estate investments involve purchasing and owning
properties such as residential, commercial, or industrial real estate,
76 PAGE
or investing in Real Estate Investment Trusts (REITs) that pool Notes

funds to invest in real estate assets.
2. Commodities: Commodities are tangible goods or primary products
that can be traded, such as precious metals (gold, silver), energy
commodities (oil, natural gas), agricultural commodities (corn,
wheat), and industrial metals (copper, aluminum).
3. Derivatives: Derivatives are financial instruments whose value derives
i
from an underlying asset. They include options, futures, and swaps,
which provide investors with exposure to various assets without
l h
directly owning them.
D e
of
4. Private Equity: Private equity involves investing in privately held
companies that are not publicly traded. Private equity firms typically
ty
acquire ownership stakes in these companies and actively manage
and improve their operations.
s i
r
5. Hedge Funds: Hedge funds are investment funds that pool capital
e
v
from accredited investors to employ various investment strategies
n i
aiming to generate returns regardless of market conditions. Hedge
U
funds typically have a higher risk tolerance and flexibility compared
to traditional investment funds.
L ,
O
6. Cryptocurrencies: Cryptocurrencies are digital or virtual currencies
S
that use cryptography for secure transactions. Bitcoin and Ethereum
L /
are examples of popular cryptocurrencies. Investing in cryptocurrencies
O
carries unique risks and opportunities due to their volatile nature
/ C
and the underlying blockchain technology.
C E
7. Art and Collectibles: Investing in art and collectibles involves
purchasing items such as paintings, sculptures, rare coins, stamps,
D
or vintage cars with the expectation that their value will appreciate
D
©
over time.
4.2.3 Benefits and Risks of Investing in Alternative Assets

Investing in alternative assets offers several potential benefits and risks
that differ from traditional investments:
PAGE 77
Notes 1. Benefits:
- Diversification: Alternative assets provide a means to diversify a
portfolio beyond stocks and bonds, potentially reducing overall risk.
- Potential Returns: Some alternative investments have historically
delivered attractive returns, such as real estate or private equity
investments.
- Inflation Hedge: Certain alternative assets, such as commodities,
have the potential to act as a hedge against inflation.
h i
e l
- Low Correlation: Alternative assets often have a low correlation
D
to traditional assets, meaning their performance may not move in
of
tandem with stock or bond markets.
2. Risks:
i ty
- Illiquidity: Many alternative investments have limited liquidity,
r s
meaning they cannot be easily bought or sold, which can restrict
e
investors’ ability to access their funds.
v
i
- High Minimum Investments: Some alternative assets, like private equity
n
U
or hedge funds, may have high minimum investment requirements,
,
limiting access for smaller investors.
L
- Complexity: Alternative investments often involve more complex
O
S
structures, legal agreements, and strategies that may require specialized
/
knowledge or expertise to evaluate properly.
L
O
- Lack of Transparency: Compared to traditional investments, alternative
/ C
assets may have limited transparency regarding their underlying
E
valuation, performance, or risks.
D C It is crucial for investors to carefully assess the benefits and risks of
©D
alternative investments, consider their investment objectives, risk tolerance,
and seek professional advice when necessary to make informed investment
decisions.
In conclusion, diversification through alternative investment alternatives
is an essential aspect of constructing a well-rounded investment portfolio.
Understanding the benefits and risks associated with these alternatives
is key to making informed investment decisions. The following sections
will delve deeper into specific investment alternatives, their strategies,
and factors to consider when investing in each asset class.
78 PAGE
4.3 Real Estate Investments Notes
4.3.1 Introduction to Real Estate as an Investment Option

Real estate is a tangible asset class that has long been recognized as a
viable and attractive investment option. It encompasses properties such
as residential homes, commercial buildings, industrial facilities, and land.
Real estate investment offers various opportunities for investors seeking
h i
l
long-term capital appreciation, cash flow, and diversification within their
investment portfolios. This section provides an overview of real estate as
D
an investment option, highlighting its characteristics, historical performance, e
of
benefits, and factors influencing investment decisions.
ty
Real estate investments possess unique characteristics that set them apart
i
from other asset classes. Firstly, real estate is a physical asset that can
s
r
provide intrinsic value and utility. Unlike stocks or bonds, which represent
v e
ownership in a company or debt obligations, real estate offers tangible
i
properties that can generate income and appreciate in value over time.
n
U
Additionally, real estate investments often have a low correlation with
,
traditional financial markets, providing diversification benefits to investors.
L
Over the years, real estate has demonstrated a strong track record of
O
S
performance. Historically, real estate investments have shown the potential
/
for attractive returns, especially in the long term. These returns are
L
O
driven by factors such as property appreciation, rental income, and tax
C
advantages associated with real estate ownership. Furthermore, real estate
E /
has the potential to act as a hedge against inflation, as rental income and
C
property values tend to increase with rising prices.
D
Investing in real estate offers several benefits that make it an appealing
©D
option for investors. Firstly, real estate investments can provide a steady
stream of cash flow through rental income. This income can serve as a
stable source of passive income, especially in the case of well-located
and well-managed properties. Additionally, real estate investments offer
the potential for capital appreciation over time, enabling investors to
build wealth through property value appreciation.
Real estate also provides the opportunity for leveraging. Investors can
finance a significant portion of a property’s purchase price through
PAGE 79
Notes mortgages or other forms of debt. By using leverage, investors can amplify
their returns, as they benefit from the appreciation of the property value
based on the total investment rather than just their initial equity.
Furthermore, real estate investments offer the possibility of tax advantages.
Investors can take advantage of deductions such as mortgage interest,
property taxes, depreciation, and other expenses related to property
ownership. These tax benefits can help reduce the overall tax liability
i
and enhance the investment returns.
When considering real estate as an investment option, several factors
l h
D e
influence investment decisions. Location plays a critical role in the
success of a real estate investment. Factors such as proximity to amenities,
of
transportation, schools, and economic growth indicators can significantly
impact the desirability and potential returns of a property.
i ty
Market conditions and trends also play a crucial role in real estate
r s
investment decisions. Understanding supply and demand dynamics, vacancy
e
rates, rental yields, and projected market growth can help investors make
v
i
informed decisions about which types of properties and locations are most
n
U
likely to generate favorable returns.
L ,
Moreover, investors need to assess their risk tolerance, investment horizon,
and financial goals when considering real estate investments. Real estate
S O
is typically considered a long-term investment, and investors should be
/
prepared for illiquidity and potential fluctuations in property values.
L
C O
4.3.2 Types of Real Estate Investments
E /
C
Real estate investments offer a range of opportunities for investors to allocate
D
their capital across different property types and strategies. Understanding
©D
the various types of real estate investments is essential for diversifying
a portfolio and aligning investment choices with specific goals and risk
preferences. This section provides an overview of different types of real
estate investments, including residential properties, commercial properties,
industrial properties, specialized properties, and land and development.
1. Residential Properties:
- Residential properties encompass homes and dwellings where individuals
or families reside.
80 PAGE
- Types of residential properties include single-family homes, multi- Notes

family properties (apartment buildings, condominiums), and vacation
homes.
- Investment potential in residential properties includes rental income,
property appreciation, and potential tax advantages.
- Residential real estate investment strategies include long-term rental
properties, fix-and-flip, and vacation rentals.
2. Commercial Properties:
h i
- Commercial properties are properties used for business or commercial
e l
D
purposes.
of
- Commercial properties include office buildings, retail spaces (malls,
strip centers), hospitality (hotels, resorts), and mixed-use developments.
i ty
- Investing in commercial properties offers potential income from lease
r s
agreements, capital appreciation, and potential tax advantages.
v e
- Commercial real estate investment requires analysis of market demand,
location, tenant quality, and lease structures.
n i
U
3. Industrial Properties:
L ,
- Industrial properties are properties used for industrial or manufacturing
O
purposes.
/ S
- Industrial properties include warehouses, distribution centers,
O L
manufacturing facilities, and logistics properties.
- Investment potential in industrial properties is driven by factors
/ C
such as increased e-commerce demand, supply chain dynamics, and
E
proximity to transportation hubs.
C
D
- Industrial real estate investment strategies involve leasing properties
©D
to logistics companies, manufacturers, or distribution firms.
4. Specialized Properties:
- Specialized properties cater to specific industries or purposes.
- Examples of specialized properties include healthcare facilities (hospitals,
medical offices), educational institutions (schools, universities),
self-storage units, and data centers.
PAGE 81
Notes - Specialized properties often require industry-specific knowledge

and analysis, but can offer unique investment opportunities and
potentially higher rental income.
5. Land and Development:
- Land and development involve investing in undeveloped or raw land
and participating in the development process.
- Investment potential in land and development comes from the
i
appreciation of land value as it is developed or rezoned for specific
h
purposes.
e l
D
- Land and development investments require careful evaluation of
of
zoning regulations, infrastructure development, and market demand
for the intended use.
ty
Each type of real estate investment comes with its own set of risks,
s i
rewards, and considerations. Factors to consider when investing in real
e r
estate include location, market conditions, property condition, financing
i v
options, tenant quality, and potential regulatory changes. It is essential for
U n
investors to conduct thorough due diligence and assess their investment
goals, risk tolerance, and time horizon to select the most suitable real
,
estate investment type for their portfolio.
L
O
By diversifying across different types of real estate investments, investors
/ S
can potentially benefit from various income streams, potential appreciation,
O L
and risk mitigation. Additionally, the specific investment strategies within
each property type may offer different opportunities for generating returns,
/ C
such as long-term rental income, property renovations, or development
C E projects.
D 4.3.3 Real Estate Investment Trusts (REITs)

©D Real Estate Investment Trusts (REITs) are a popular investment vehicle
that allows individuals to invest in real estate without directly owning and
managing properties. REITs offer investors the opportunity to access the
benefits of real estate ownership, such as rental income and potential capital
appreciation, while providing diversification, liquidity, and professional
management. This section explores the definition, types, benefits, and
considerations associated with investing in REITs.
82 PAGE
1. Definition and Structure of REITs: Notes

- REITs are companies that own, operate, or finance income-generating
real estate properties.
- They are created as special investment vehicles that comply with
specific legal and tax requirements.
- REITs pool investors’ capital to acquire and manage a portfolio of
properties, which can include commercial, residential, industrial,
and specialized properties.
h i
- They are required to distribute a significant portion of their taxable
e l
D
income as dividends to shareholders.
of
2. Types of REITs:
- Equity REITs: The majority of REITs fall into this category. Equity
i ty
REITs own and operate income-generating properties, generating
revenue primarily through rental income.
r s
e
- Mortgage REITs: Mortgage REITs invest in mortgages and mortgage-
v
i
backed securities, earning income from interest payments on these
n
U
loans.
L ,
- Hybrid REITs: Hybrid REITs combine elements of both equity and
mortgage REITs, investing in both properties and mortgages.
S
3. Benefits of Investing in REITs: O
L /
- Diversification: REITs provide diversification within the real estate
O
sector, as they invest in various types of properties across different
C
/
locations and markets.
E
- Access to real estate: Investing in REITs allows individuals to
C
D
participate in the real estate market without the need for significant
©D
capital or direct property ownership.
- Liquidity: REITs are traded on stock exchanges, providing investors
with the ability to buy and sell shares easily.
- Professional management: REITs are managed by experienced
professionals who handle property acquisition, management, and
leasing, reducing the burden on individual investors.
PAGE 83
Notes - Potential for income: REITs are required to distribute a significant

portion of their taxable income to shareholders, providing the
potential for consistent dividend income.
- Potential for capital appreciation: REITs can experience capital
appreciation over time as the value of their underlying real estate
holdings increases.
4. Drawbacks and Considerations:
- Market sensitivity: The performance of REITs can be influenced by
h i
l
real estate market conditions, interest rates, and economic factors.
e
D
- Dividend taxation: Dividends received from REITs may be subject
of
to different tax treatment compared to other investments, so it is
important to understand the tax implications.
ty
- Management fees: Some REITs may charge management fees and
s i
expenses, which can impact overall returns.
e r
- Share price volatility: Like other publicly traded securities, the share
i v
price of REITs can be subject to market volatility.
U n
- Real estate market risks: REITs are exposed to risks associated
,
with real estate investments, such as changes in property values,
L
vacancies, and lease renewals.
O
S
5. Investing in REITs:
L /
- Direct investment: Investors can purchase shares of publicly traded
O
REITs on stock exchanges.
/ C
- Publicly traded REITs: These are REITs that are listed and traded
C E on stock exchanges, offering liquidity and transparency.
D
- Non-traded REITs: Non-traded REITs are not listed on stock exchanges
©D
and typically have limited liquidity.
- Due diligence: It is crucial to conduct thorough research on REITs,
including analyzing their financials, management team, investment
strategy, and property portfolio.
In conclusion, REITs provide individuals with a convenient and accessible
way to invest in real estate. They offer diversification, liquidity, and the
potential for income and capital appreciation. However, investors should
carefully consider their investment objectives, risk tolerance, and perform
due diligence on specific REITs before making investment decisions.
84 PAGE
REITs can be an effective addition to an investment portfolio, allowing Notes

individuals to participate in the real estate market while benefiting from
professional management and potential returns.
4.4 Commodities Investing
4.4.1 Understanding Commodities
h i
Commodities are essential raw materials or primary goods that can be
traded in the market. Investing in commodities allows individuals to
e l
D
of
gain exposure to these tangible assets and potentially benefit from price
movements:
ty
Commodities are tangible assets that can be classified into different
i
categories: agriculture (wheat, corn, soybeans), energy (crude oil,
s
r
natural gas), metals (gold, silver, copper), and others (livestock,
e
v
lumber).

n i
The value of commodities is influenced by various factors, including
and global economic trends.

, U
supply and demand dynamics, geopolitical events, weather conditions,
O L
Commodities have both industrial and investment uses, making them
/ S
an essential component of the global economy.
O L
4.4.2 Benefits of Commodities Investing
/ C

C E
Diversification: Investing in commodities can provide diversification
benefits as their performance may have a low correlation with
D
traditional asset classes like stocks and bonds. Commodities tend
©D
to behave differently than financial assets and can help reduce
portfolio risk.
Inflation Hedge: Commodities have historically been considered an
effective hedge against inflation. When inflation rises, the prices of
commodities tend to increase as well, allowing investors to protect
the value of their assets.
Potential for Capital Appreciation: Commodities can experience
price volatility due to various factors such as supply and demand
PAGE 85
Notes imbalances, geopolitical tensions, or natural disasters. This volatility

creates opportunities for active traders and long-term investors to
potentially profit from price movements.
Portfolio Protection: During times of economic uncertainty or market
downturns, commodities can act as a hedge. Their prices may move
independently of traditional financial assets, providing a potential
safeguard against losses.
h i
l
4.4.3 Risks and Challenges

D e
Price Volatility: Commodities are known for their price volatility.
of
Sudden changes in supply and demand, geopolitical events, or natural
disasters can lead to significant price fluctuations. Investors must
ty
be prepared for the inherent volatility of commodities markets.
s i
r
Market Complexities: Investing in commodities requires an under-
e
standing of specific market dynamics, such as futures contracts,
i v
spot prices, and supply chain factors. Investors need to grasp the
n
intricacies of these markets to make informed decisions.
U
,
Storage and Transportation Costs: Some commodities, such as
O L
crude oil or agricultural products, require storage and transportation
facilities, which can add additional costs and logistical challenges
/ S
for investors.

O L
Regulatory and Political Risks: Government policies, regulations,
C
and political instability in commodity-producing countries can
E / significantly impact prices and investment returns. Investors need
C
to stay informed about geopolitical developments and regulatory
D
changes that could affect their commodity investments.
©D
Lack of Income: Unlike stocks or bonds that may provide regular
income through dividends or interest payments, commodities typically
do not generate ongoing income. Investors primarily rely on price
appreciation to generate returns.
4.4.4 Methods of Investing in Commodities

Futures Contracts: One way to invest in commodities is through
futures contracts. Investors can enter into agreements to buy or sell
86 PAGE
a specific quantity of a commodity at a predetermined price and Notes

future date. Futures contracts allow investors to gain exposure to
commodities without owning the physical asset.
Exchange-Traded Funds (ETFs): ETFs offer investors the opportunity
to gain exposure to a basket of commodities or specific commodity
sectors without directly trading futures contracts. These funds can
provide diversification and are traded on stock exchanges, offering
i
liquidity.
Physical Ownership: Some investors prefer to physically own
l h
commodities. For example, they may purchase gold bullion or
agricultural products. Physical ownership allows investors to have
D e
of
direct control over the asset and potentially benefit from its long-
term value appreciation.
Commodity-Linked Stocks: Investing in stocks of companies
i ty
r s
involved in commodity production, exploration, or distribution can
e
provide indirect exposure to commodities. These stocks may move
v
i
in tandem with commodity prices and allow investors to participate
n
U
in the commodity sector.

L ,
Mutual Funds: Mutual funds focused on commodities or commodity-
related companies provide diversified exposure to the commodity
S O
sector. These funds are managed by professionals who analyze and
/
select commodities or commodity-related investments on behalf of
L
O
the investors.
/ C
E
4.4.5 Factors to Consider when Investing in Commodities

D C
Market Analysis: Understanding supply and demand dynamics,
©D
geopolitical factors, weather patterns, and economic trends is crucial
when assessing commodity investment opportunities. Investors need
to conduct thorough research and stay informed about factors that
can impact commodity prices.
Risk Management: Managing risks is essential in commodities
investing. Investors can employ various risk management strategies,
such as setting stop-loss orders, diversifying their commodity holdings
across different sectors, or using options and futures contracts to
hedge against price volatility.
PAGE 87
Notes Investor Knowledge and Expertise: Investing in commodities

requires familiarity with specific markets, pricing mechanisms, and
risk management techniques. Investors should educate themselves
or seek professional advice before entering this asset class to make
informed investment decisions.
Time Horizon and Investment Objectives: The time horizon and
investment goals of an individual will influence the choice between
i
short-term trading or long-term investment strategies in commodities.
l h
Investors should align their investment approach with their objectives,
e
whether it is capital appreciation, income generation, or portfolio
diversification.
D
of
By considering these factors and conducting thorough research, investors
can make informed decisions when investing in commodities. Commodities
i ty
offer unique characteristics and potential benefits, but they also carry
r s
risks and require careful analysis and risk management.
v e
4.5 Derivative Instruments
n i
U
Derivatives are financial instruments that derive their value from an
,
L
underlying asset, such as stocks, bonds, commodities, or currencies. They
O
serve as tools for managing risk, speculating on price movements, and
/ S
generating income. In this section, we will explore derivatives investments,
O L
including an introduction to derivatives, the types of derivatives, and
strategies for investing in derivatives.
C
/ Introduction
C E4.5.1
D D - Definition: Derivatives are contracts between two parties that derive
©
their value from an underlying asset. The value of a derivative is
based on the price movements of the underlying asset. Derivatives
can be traded on exchanges or over-the-counter (OTC).
- Purpose: Derivatives serve various purposes, including risk management,
speculation, and income generation. They enable investors to hedge
against price fluctuations, take speculative positions on market
movements, and generate income through options premiums or
interest rate differentials.
88 PAGE
4.5.2 Types of Derivatives Notes
There are several types of derivatives, each with its own characteristics
and applications. The main types of derivatives include:
- Long Futures Contract Payoff: If an investor enters into a long
futures contract, their payoff will increase as the price of the
underlying asset rises. For example, if a trader buys a futures contract
for crude oil at $60 per barrel and the price increases to $70 per
barrel at expiration, they will make a profit of $10 per barrel.
h i
- Short Futures Contract Payoff: If an investor enters into a short
e l
futures contract, their payoff will increase as the price of the
D
of
underlying asset decreases. For instance, if a trader sells a futures
contract for wheat at $0.5 per kg and the price falls to $0.4 per kg
at expiration, they will make a profit of $0.1 per kg.
i ty
r s
The predetermined price at which the underlying futures contract is to
e
be bought or sold is called the strike price. It is usually denoted by K.
v
n i
, U
O L
/ S
O L
/ C
C E
D
©D
1. Options Contracts: Options give the holder the right, but not the
obligation, to buy (call option) or sell (put option) an underlying asset
at a predetermined price within a specified period. Options can be used
for hedging against potential losses or for speculative purposes.
- Call Option Payoff: Suppose an investor purchases a call option
on a stock with a strike price of $50 and the market price of the
stock rises to $60. In this case, the investor can exercise the call
PAGE 89
Notes option, buy the stock at the lower strike price, and sell it at the
higher market price, resulting in a profit of $10 per share.
- Put Option Payoff: If an investor buys a put option on a stock with
a strike price of $100 and the market price of the stock falls to
$90, the put option can be exercised. The investor can then sell
the stock at the higher strike price, resulting in a profit of $10 per
share.
h i
e l
D
of
i ty
r s
v e
n i
, U
O L
/ S
O L
2. Swaps: Swaps are agreements between two parties to exchange cash
flows or other financial instruments. Common types of swaps include
/ C
interest rate swaps, currency swaps, and commodity swaps. Swaps are
C Eoften used to manage interest rate or currency risks.
D
- Interest Rate Swap Payoff: In an interest rate swap, the payoff is
©D
based on the difference between fixed and floating interest rates.
For example, if a company enters into an interest rate swap where
it pays a fixed rate of 4% and receives a floating rate of LIBOR,
and at the end of the swap period, LIBOR is at 3%, the company
will receive a net payment of 1%.
- Currency Swap Payoff: In a currency swap, the payoff depends
on the exchange rate between two currencies. For instance, if a
company enters into a currency swap to exchange USD for EUR
90 PAGE
at an agreed exchange rate of 1.2, and at the end of the swap, the Notes
exchange rate is 1.5, the company will receive a benefit of 0.3 EUR
for each USD swapped.
3. Forward Contracts: Forward contracts are similar to futures
contracts but are privately negotiated between two parties. They allow
for customization of terms and are not traded on exchanges. Forward
contracts are commonly used in over-the-counter markets for hedging or
i
speculative purposes. Payoff -
- Long Forward Contract Payoff: If an investor enters into a long
l h
forward contract to buy gold at $61,000 per kg, and at the expiration
date, the market price of gold is $65,000 per kg, the investor can
D e
of
buy the gold at the lower contract price and sell it at the higher
market price, resulting in a profit.
i
- Short Forward Contract Payoff: If an investor enters into a short
ty
r s
forward contract to sell wheat at $0.6 per kg, and at expiration,
e
the market price of wheat is $0.5 per kg, the investor can buy the
v
i
wheat at the lower market price and sell it at the higher contract
n
U
price, resulting in a profit.
L ,
4. Options on Futures: Options on futures are similar to options contracts
but are based on futures contracts as the underlying asset. They provide
S O
flexibility for investors to trade options on various commodities or
financial instruments.
L /
O
Differences between futures and options -
Basic of
/ C
Futures Options
Comparison
Meaning
C E
Futures contract is a binding Options are the contract in which
D
agreement, for buying and the investor gets the right to buy
©D
selling of a financial instrument or sell the financial instrument at
at a predetermined price at a a set price, on or before a certain
future specified date date, however the investor is not
obligated to do so
Obligation of Yes, to execute the contract No, there is no obligation
buyer
PAGE 91
Notes Basic of Futures Options

Comparison
Execution of On the agreed date Anytime before the expiry of the
contract agreed date
Risk High Limited
Advance No advance payment Paid in the form of premiums
payment
Degree of Unlimited Unlimited profit and limited loss
profit/loss
h i
Strategies for Investing in Derivatives
e l
D
Investors can employ different strategies when investing in derivatives,
of
depending on their investment objectives and risk tolerance. Here are
three common strategies:
i ty
1. Hedging: Hedging involves using derivatives to offset potential losses
r s
in an investment portfolio. For example, a stock investor concerned
e
about a potential market downturn can use stock index futures to
v
n i
hedge against a decline in the overall market. By taking a short
position in futures contracts, any losses in the stock portfolio can
, U
be offset by gains in the futures contracts.
O L
2. Speculation: Speculation involves taking positions in derivatives
with the aim of profiting from price movements. Speculators may
/ S
buy or sell futures contracts or options contracts based on their
L
predictions of future price movements. Speculative strategies in
O
C
derivatives carry higher risks and require a thorough understanding
/ of the market and potential factors influencing prices.
CE
3. Income Generation: Derivatives can also be used to generate income.
D D For example, selling covered call options on stocks held in a portfolio

can generate premium income. If the stock price remains below the
© exercise price of the call options, the investor keeps the premium
and continues to hold the stock. However, if the stock price rises
above the exercise price, the investor may have to sell the stock
at a predetermined price.
Conclusion
Derivative investments offer a range of opportunities for investors, including
risk management, speculation, and income generation. Understanding
92 PAGE
the different types of derivatives and their applications is essential for Notes
investors looking to incorporate derivatives into their investment strategies
It is important to consider the risks associated with derivatives, such as
price volatility, leverage, and counterparty risk. Investors should conduct
thorough research, seek professional advice, and carefully assess their
risk tolerance before engaging in derivatives investments.
i
4.6 Other Alternative Asset Classes
l h
4.6.1 Private Equity
D e
of
Private equity is an investment strategy that involves investing in privately-
ty
held companies that are not publicly traded on stock exchanges. This form
i
of investment is typically undertaken by institutional investors, such as
s
r
private equity firms, pension funds, and wealthy individuals.
e
i v
Definition and Structure: Private equity involves purchasing ownership
n
stakes in companies with the aim of generating significant returns over a
, U
specific time period. Unlike public companies, which have shares traded
on stock exchanges, private equity investments are made in companies
L
that are not accessible to the general public. Private equity firms raise
O
S
capital from investors and use it to acquire stakes in target companies,
L /
often with the goal of improving their operations, expanding their market
O
share, and ultimately realizing a profitable exit.
/ C
Types of Private Equity: Private equity investments can be categorized
C E
into different types based on the stage of the company’s development.
These include venture capital, which focuses on early-stage companies
D
with high growth potential; growth equity, which invests in established
©D
companies seeking capital for expansion; and leveraged buyouts, which
involve acquiring established companies using a combination of equity
and debt.
Returns and Risks: Private equity investments offer the potential for
significant returns. However, they also carry certain risks. The illiquid
nature of private equity means that investors may not have immediate
access to their capital, as investments are typically held for several years.
Moreover, the success of private equity investments depends on factors
PAGE 93
Notes such as the overall performance of the company, market conditions,

and the expertise of the private equity firm. Additionally, private equity
investments are subject to higher risks compared to publicly traded
securities, as the companies may face challenges and uncertainties that
can impact their valuation.
4.6.2 Hedge Funds
h
Hedge funds are alternative investment vehicles that pool capital from
i
e l
accredited investors and employ various strategies to generate returns.
D
These funds are managed by professional fund managers and often have
of
the flexibility to invest in a wide range of financial instruments. Here
are the key points to consider when discussing hedge funds:
ty
Definition and Structure: Hedge funds are privately organized investment
s i
funds that are typically open to a limited number of accredited investors.
e r
They are structured as limited partnerships or limited liability companies.
i v
Hedge funds aim to generate positive returns regardless of market conditions
n
by employing a diverse range of investment strategies.
U
Investment Strategies: Hedge funds utilize a variety of investment
,
L
strategies, including long and short positions, leverage, derivatives, and
O
arbitrage. These strategies allow hedge fund managers to potentially profit
/ S
from both rising and falling markets. Some common hedge fund strategies
O L
include equity hedge (long and short positions in stocks), global macro
(investing based on macroeconomic trends), event-driven (trading around
/ C
corporate events), and managed futures (trading in futures contracts).
C EPerformance and Returns: Hedge funds aim to achieve absolute returns,
D
meaning they seek positive returns regardless of the overall market
©D
performance. Hedge fund managers often strive to outperform traditional
market indices or deliver positive returns in both up and down markets.
However, hedge fund performance can vary significantly, and not all funds
achieve consistent or positive returns. Investors should carefully assess
a hedge fund’s track record, risk management practices, and investment
strategy before investing.
Fee Structure: Hedge funds typically charge management fees and
performance fees. The management fee is a percentage of the assets
94 PAGE
under management and is typically charged annually. Performance fees, Notes

also known as incentive fees, are based on a percentage of the profits
earned by the fund. The fee structure is intended to align the interests
of the fund manager with those of the investors.
4.6.3 Cryptocurrencies and NFTs

Cryptocurrencies are digital or virtual currencies that use cryptography
for security and operate on decentralized networks called blockchain.
h i
Bitcoin, Ethereum, and Ripple are some well-known cryptocurrencies.
e l
D
As investment assets, cryptocurrencies offer several potential benefits:
of
- Potential for High Returns: Cryptocurrencies have demonstrated
the potential for substantial returns over relatively short periods.
ty
However, it is important to note that they can also experience
s i
significant price volatility, and there is no guarantee of future
performance.
e r
i v
- Portfolio Diversification: Cryptocurrencies can provide diversification
U n
benefits as they have a low correlation with traditional asset classes
like stocks and bonds. Including cryptocurrencies in an investment
L ,
portfolio may help reduce overall risk.
O
- Accessibility and Liquidity: Cryptocurrencies offer global accessibility
S
/
and can be bought and sold on various cryptocurrency exchanges.
O L
The liquidity of cryptocurrencies allows investors to enter or exit
positions relatively quickly.
/ C
- Technological Innovation: Cryptocurrencies are built on blockchain
E
technology, which has the potential to revolutionize various industries.
C
D
Investing in cryptocurrencies allows investors to participate in this
©D
technological innovation.
Non-Fungible Tokens (NFTs): NFTs are unique digital assets that are
verifiable and indivisible, utilizing blockchain technology for authentication
and ownership records. NFTs represent ownership or proof of authenticity
of digital assets such as artwork, music, collectibles, and virtual real
estate. Key points to consider regarding NFTs as investments include:
Unique and Scarce Assets: NFTs represent ownership of unique
digital items, creating scarcity and exclusivity. This uniqueness can
contribute to their value and potential for appreciation.
PAGE 95
Notes Art and Collectibles: NFTs have gained significant popularity in the
art and collectibles market. Artists and creators can tokenize their
works as NFTs, enabling direct ownership and the potential for
monetization through sales and royalties.
Digital Ownership and Authenticity: NFTs provide proof of ownership
and authenticity for digital assets, addressing the issue of digital
duplication and piracy. This aspect has attracted interest from
i
collectors and investors seeking unique digital assets.

l h
Market Volatility: NFT prices can experience substantial volatility,
D e
driven by factors such as market demand, popularity of the underlying
digital asset, and overall market sentiment. NFT investments can
of
involve significant risks due to the nascent nature of the market
and the potential for rapid changes in value.
i ty
4.6.4 Peer-to-Peer Lending
r s
v e
i
Peer-to-peer (P2P) lending, also known as marketplace lending, is an
U n
alternative investment option that allows individuals and small businesses
to borrow and lend money directly through online platforms. Here are
L ,
the key points to consider when discussing P2P lending as an investment:
O
- Definition and Structure: P2P lending platforms connect borrowers
S
L /
and lenders directly, cutting out traditional financial intermediaries
such as banks. Borrowers submit loan applications on the platform,
O
and lenders can review the loan requests and choose to fund them.
C
E / The platform facilitates the loan process, including loan origination,
repayment, and collections.
D C - Potential Returns: P2P lending offers the potential for attractive
©D
returns compared to traditional fixed-income investments. As lenders,
investors earn interest on the loans they fund. The interest rates
are typically determined based on factors such as the borrower’s
creditworthiness and the perceived risk of the loan. However, it is
important to note that higher returns are typically associated with
higher risk loans.
- Risk and Default: P2P lending carries certain risks. The primary
risk is the potential for borrowers to default on their loan payments.
P2P lending platforms employ credit assessment models to evaluate
96 PAGE
borrowers’ creditworthiness, but there is still a risk of loan defaults. Notes

Lenders should carefully consider the risk levels associated with
different borrowers and diversify their investments to mitigate
potential losses.
- Regulation and Investor Protection: P2P lending is subject to varying
degrees of regulation in different jurisdictions. Some countries have
established regulatory frameworks to govern P2P lending platforms
i
and protect investor interests. Investors should ensure that they
understand the regulatory environment and any investor protection
l h
e
mechanisms in place.
IN-TEXT QUESTIONS
D
1. What is the key difference between a futures contract and a
of
ty
forward contract?
s i
(a) Futures contracts are standardized and traded on exchanges,
r
while forward contracts are privately negotiated
e
i v
(b) Futures contracts are only used for speculation, while
U n
forward contracts are primarily used for hedging
(c) Futures contracts have a longer expiration period than
forward contracts
L ,
O
(d) Futures contracts have fixed prices, while forward contracts
S
L /
have variable prices
2. Which strategy involves using derivatives to offset potential
C O
losses in an investment portfolio?
E /
(a) Speculation
C
(b) Income Generation
D
©D
(c) Hedging
(d) Risk Tolerance
3. What is a common investment strategy associated with private
equity?
(a) Day trading on stock exchanges
(b) Investing in publicly traded companies
(c) Purchasing ownership stakes in privately-held companies
(d) Speculating on cryptocurrency price movements
PAGE 97
Notes 4. What is a key characteristic of Non-Fungible Tokens (NFTs)?

(a) They are highly correlated with traditional asset classes
like stocks
(b) They can be divided into smaller units for investment
purposes
(c) NFTs provide proof of ownership and authenticity for
digital assets
h i
l
(d) NFT prices are stable and do not experience volatility
e
5. What is one of the benefits of investing in commodities?
D
of
(a) Immediate access to invested capital
(b) High correlation with traditional asset classes
i
(c) Potential for capital depreciation
ty
r s
(d) Effective hedge against inflation
v e
6. Which method of investing in commodities allows investors
n i
to gain exposure to commodities without owning the physical
U
asset?
,
(a) Physical Ownership
L
O
(b) Exchange-Traded Funds (ETFs)
/ S
(c) Commodity-Linked Stocks
O L
(d) Mutual Funds
C
7. What is one of the benefits of investing in Real Estate Investment
E / Trusts (REITs)?
D C (a) Direct ownership and management of properties
©D
(b) Lack of liquidity and ease of trading
(c) Tax benefits on dividends
(d) Limited diversification within the real estate sector
8. Which type of REIT primarily generates revenue through rental
income from income-generating properties?
(a) Equity REIT
(b) Mortgage REIT
98 PAGE
(c) Hybrid REIT Notes
(d) Non-traded REIT

9. What is one of the key reasons why diversification is important
in investment portfolios?
(a) To maximize short-term gains
(b) To eliminate all investment risks
(c) To smooth out investment returns over time
h i
(d) To rely heavily on the performance of a single investment
e l
10. Which of the following is NOT mentioned as an example of
D
of
an alternative investment?
(a) Stocks
(b) Hedge funds
i ty
(c) Cryptocurrencies
r s
v e
i
(d) Art and collectibles
4.7 Summary
U n
L ,
Diversification is a crucial principle in investing that involves spreading
O

S
capital across various assets to reduce risk and enhance returns. It
L /
helps mitigate market volatility, smooth out returns, protect against
O
catastrophic losses, and expose investors to different opportunities.

/ C
To effectively diversify a portfolio, investors should consider a
C E
mix of asset classes, industries, geographic regions, and investment
strategies. Alternative investment alternatives include real estate,
D
commodities, derivatives, private equity, hedge funds, cryptocurrencies,
©D
art, and collectibles.
Real estate is a tangible asset class that offers long-term capital
appreciation, cash flow, and diversification for investors. It is a
physical asset with intrinsic value and low correlation with traditional
financial markets. Real estate investments provide steady cash flow
through rental income and potential capital appreciation over time.
PAGE 99
Notes There are three main types of real estate investments:

z Residential properties: include single-family homes, and
vacation homes.
z Commercial properties: which include office buildings, retail
spaces, and mixed-use developments.
z Industrial properties: such as warehouses and distribution
centers, offer investment potential due to factors like e-commerce
demand and transportation hub proximity.
h i

e l
Real Estate Investment Trusts (REITs) provide diversification, liquidity,
D
and professional management without owning and managing properties.
of
REITs are companies that own, operate, or finance income-generating
real estate properties. They are special investment vehicles that meet
ty
legal and tax requirements.

s i
Commodities are essential raw materials and primary goods traded
e r
in the market. They offer diversification, inflation hedges, capital
i v
appreciation opportunities, and portfolio protection. However, they
U n
also present risks such as price volatility, market complexity, storage
and transportation costs, and regulatory and political risks.

L ,
Investing methods in Commodities include:
z
S O
Futures contracts
z
L /
Exchange-traded funds (ETFs)
O
z Physical ownership
/ C z Commodity-linked stocks
CE
z Mutual funds
D D Physical ownership allows direct control over the asset, while commodity-
linked stocks provide indirect exposure to the commodity sector. Commodity
© funds are managed by professionals who analyze and select investments:

Derivatives are financial instruments that derive their value from an
underlying asset, such as stocks, bonds, commodities, or currencies.
They serve various purposes, including risk management, speculation,
and income generation. There are several types of derivatives -
z Forwards and Futures: which are standardized contracts traded
on exchanges. The payoffs for long futures contracts increase
100 PAGE
as the underlying asset price rises, while short futures contracts Notes
increase as the asset price decreases.
z Options: give investors the right to buy or sell an underlying
asset at a predetermined price within a specified period.
They can be used for hedging against potential losses or for
speculative purposes.
z Swaps: such as interest rate swaps, currency swaps, and
i
commodity swaps, are agreements between parties to exchange
cash flows or financial instruments. The payoff depends on the
l h
difference between fixed and floating interest rates. Forward
contracts, similar to futures contracts, are privately negotiated
D e
of
and are commonly used in over-the-counter markets for hedging
or speculative purposes.
Other alternative asset classes include -
i ty
r s
Private equity: an investment strategy that involves investing
e
z
v
in privately-held companies not publicly traded on stock
n i
exchanges. They carry risks, such as illiquidity and varying
U
returns depending on factors like company performance, market
,
conditions, and the expertise of the private equity firm.
L
O
z Hedge funds: They use various investment strategies, such
S
as global macro, event-driven trading, and managed futures,
L /
to profit from both rising and falling markets. They charge
O
management and performance fees, aligning fund manager
/ C
interests with investors’ interests.
z
C E
Cryptocurrencies: they offer potential high returns, portfolio
diversification, accessibility, liquidity, and technological
D
innovation. NFTs are unique digital assets using blockchain
©D
technology for authentication and ownership records. They
represent ownership and authenticity of digital assets like
artwork, music, collectibles, and virtual real estate.
z P2P lending: it is an investment that connects borrowers and
lenders directly, facilitating the loan process. It offers attractive
returns, but carries risks of default and regulatory scrutiny.
Lenders should carefully consider risk levels and diversify
investments to mitigate losses.
PAGE 101
Notes 4.8 Answers to In-Text Questions
1. (a) Futures contracts are standardized and traded on exchanges,

while forward contracts are privately negotiated
2. (c) Hedging
3. (c) Purchasing ownership stakes in privately-held companies
4. (c) NFTs provide proof of ownership and authenticity for digital
assets
h i
5. (d) Effective hedge against inflation
e l
6. (b) Exchange-Traded Funds (ETFs)
D
of
7. (c) Tax benefits on dividends
ty
8. (a) Equity REIT
s i
9. (c) To smooth out investment returns over time
10. (a) Stocks
e r
i v
U n
L ,
1. Why is diversification important? How can it be achieved?
O
2. What are the various considerations involved in real estate investing?
S
/
3. Describe the various kinds of real estate investments.
L
O
4. List down the various types of commodities and the risks associated
/ C
with investing in them.
C E 5. What is the difference between the various kinds of derivatives?
D
6. Write short notes on the following —
©D
Private Equity
Hedge Funds
Cryptocurrencies
P2P Lending
102 PAGE
4.10 References Notes
Hirtle, B. J., & Pritchard, J. C. (2011). Alternative investments:

Instruments, performance, benchmarks, and strategies. Wiley.
Pattnaik, S., & Gupta, S. (2015). Alternative investments: CAIA
Level II. Wiley India.
Anson, M. J. P., & Gilmartin, B. (2013). Handbook of alternative
i
assets (2nd ed.). Wiley.
Ferri, R. A. (2010). All about asset allocation (2nd ed.). McGraw-
l h
Hill.
D e
of
Ray, S. (2014). Alternative investments: A practitioner’s guide to
asset allocation, strategy, and risk (2nd ed.). Elsevier India.
i ty
r s
v e
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, U
O L
/ S
O L
/ C
C E
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PAGE 103
L E S S O N
5
Modern Portfolio Theories
Ms. Iti Verma
Assistant Professor
Gargi College
University of Delhi
h i
STRUCTURE
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D
of
5.2 Introduction
5.3 Concept of Portfolio
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5.4 Portfolio Management
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5.5 Concept of Portfolio Risk and Return
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5.6 5HODWLRQVKLSEHWZHHQ&RHI¿FLHQWRI&RUUHODWLRQ3RUWIROLR5LVNDQG'LYHUVL¿FDWLRQ
5.7 Modern Portfolio Theories
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5.8 Solved Illustrations
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S
5.9 Summary
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5.12 References C
5.13 Suggested E
/
C
Readings
D
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Understand the concept and process of portfolio management.
Understand the concept of portfolio risk and return.
Understand modern portfolio theories.
104 PAGE
MODERN PORTFOLIO THEORIES
Individual securities have their own risk and return characteristics.

The expected future returns from security are variable in nature and
the uncertainty of returns is known as risk. An investor never chooses
to invest all of his savings in an individual security/asset. Rather, any
investor needs to invest in a variety of financial securities simultaneously.
The underlying idea is “Not to Put All the Eggs in One Basket”. It is an
attempt to diversify and minimize risk, hence, the loss in one security
h i
will be compensated by the gain in others. The investment of money in
e l
D
a variety of securities to attain maximum return with a minimum level
of
of risk leads us to the idea of a portfolio. The present chapter explains
the concept of portfolio management and its theories to achieve portfolio
ty
optimisation.
s i
5.3 Concept of Portfolio
e r
i v
A collection of securities together for an investment is termed a portfolio.
U n
For instance, an investor plans to invest his funds in shares of ABC Ltd.
,
Alternatively, he can invest his funds in the shares of 5 different companies
O L
in equal proportion. In the former case, he will be exposed to high risk
as the expected returns of all the investments made by him, will depend
/ S
upon the performance of ABC Ltd. However, in the latter case, his risk
O L
will diversify as he invests his funds in different companies, hence, the
loss in one share may be offset by the profits earned in other shares and
/ C
ultimately portfolio risk will be reduced.
C E
There can be any number of portfolios that can be constructed from
D
a given set of securities. A wise investor always prefers to choose the
©D
most efficient portfolio to meet his investment objectives. The efficient
portfolio attempts to maximize return at a given risk appetite.
5.4 Portfolio Management

Portfolio management involves the process of formulation, maintenance,
revision and continuous evaluation of a portfolio. The steps involved
are with the intent to manage the portfolio in such a way that helps in
PAGE 105
Notes maximisation of return with the given risk profile of the investor. The
steps involved in managing the combination of different securities that
are held in a portfolio can be understood with the help of the flowchart
shown in Figure 5.1. The five steps process for portfolio management
is described below:
h i
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D
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L
Figure 5.1: Process of Portfolio Management
O
S
(a) Security Analysis: The primary step in portfolio management is
L /
to analyse the risk and return characteristics and the price level
O
of a large number of available securities in the financial market.
/ C
The available securities have been categorised as variable income
E
securities i.e., equity shares and fixed income securities including
D C bonds and debentures. Due to reforms in the financial markets,

several innovative financial instruments have been introduced.
©D
GDRs, ADRs, Convertible debentures, Floating rate bonds, Asset
Linked Bonds, and Derivatives are some of them. The investor
has to decide the financial security in which he should invest. The
security analysis can be done through the Fundamental approach, the
technical approach and the Efficient Market Hypothesis (EMH). The
Fundamental analysis attempts to determine the intrinsic value of a
security and compare it with the current market price which helps
in investment decision-making in terms of whether to buy or not to
buy the securities at the current prevailing prices. A financial analyst
106 PAGE
has to forecast the true value of security using Economy, Industry Notes
and Company-wide factors into consideration. It is known as EIC
or Top-down approach. On the other hand, the technical analysis
attempts to forecast whether the security is overpriced, under-priced
or fairly priced with the help of past trends in price and volume
data. The EMH is based on the premise that the current market
price of the securities can fully reflect all available information.
Hence, an investor can anytime buy or sell the securities.
(b) Portfolio Analysis: Once security analysis has been done, the next
h i
step is to construct an infinite number of possible portfolios based
e l
D
on information gathered through the first step i.e., security analysis.
of
It may be noted that not all the portfolios would be efficient,
thus; portfolio analysis is required to select the optimal portfolio.
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The objective of portfolio analysis is to evaluate the efficiency of
s i
different portfolios in the context of the risk and return profile
e r
of each possible portfolio which helps to identify a portfolio that
i v
provides maximum returns for a given level of risk or a minimum
n
risk for a given level of return.
U
(c) Selection of Portfolio: In this step, an investor selects the efficient
,
L
portfolio that optimises his utility given an investor’s risk and
O
return preferences. For portfolio selection, an investor constructs
/ S
the indifference curves that measure his utility scores and the
L
portfolio which maximises the utility of the investor will be taken
O
into consideration as the optimum portfolio. Two popularly known
C
/
portfolio theories i.e., Harry Markowitz Model and Capital Market
C E
Theory are used by an investor to select an optimal portfolio.
(d) Revision of Portfolio: Portfolio management is an ongoing process,
D
©D
that requires continuous monitoring of the portfolio to keep track
if there are any changes taking place concerning to risk and return
profile and price levels of the individual securities with the change
in the financial environment which in turn will bring change in
the portfolio risk and return profile. Moreover, the changes in the
financial goals or investors’ preferences require the portfolios to be
revised accordingly. The portfolio needs to be revised if additional
funds are invested. The ultimate objective is to increase the expected
returns of the portfolio.
PAGE 107
Notes (e) Evaluation of Portfolio: The evaluation of a portfolio is the last

step as well as an integral part of the portfolio management
process. Portfolio evaluation is crucial to determine whether the
selected efficient portfolios have been reaping the desired return
or not. A portfolio should be assessed periodically to evaluate its
performance in terms of risk and return. The performance of the
portfolio is compared with a market/benchmark portfolio. Those
portfolios which surpass the benchmark portfolio are held by the
investor and others are sold or may be revised according to the
h i
e l
macro-economic conditions. Some of the popular techniques used
to evaluate the performance of the portfolios are Jensen’s alpha,
D
of
Sharpe’s ratio, Treynor’s ratio etc.
IN-TEXT QUESTIONS
ty
1. A combination of various financial assets like bonds, shares,
s i
mutual funds and so on for investment is called _______.
(a) Speculation
e r
(b) Portfolio
i v
(c) Gambling
U n
,
(d) Investment
L
O
2. Techniques used to evaluate the performance of the portfolio:
/ S
(a) Treynor’s ratio
L
(b) Jensen’s ratio
CO
(c) Both (a) & (b)
E/
D C 5.5 Concept of Portfolio Risk and Return

© D The determination of the expected return and risk of the portfolio is
designated as the first step in portfolio analysis.
5.5.1 Expected Portfolio Return

The expected return of a combination of securities is defined as the
weighted average of the returns of individual assets/securities that are
held in the portfolio. For example, if an investor invests in a portfolio
108 PAGE
comprising two equity shares A and B which have expected returns of Notes
30% and 20% respectively. If 60% of the total funds are invested in
share A and 40%, in share B, then the expected portfolio return, E(Rp), is:
Portfolio Return = Weight of Security A × Return of Security A +
Weight of Security B × Return of Security B
Symbolically,
E(Rp) = (.60 × .30) + (.40 × .20)
i
= 26%
Therefore, the formula to determine the expected return on the portfolio
l h
is shown below:
n
E(Rp) = ∑ wi × E (Ri ) D e
of
i =1
ty
where,
E(Rp) = Expected Return on Portfolio
s i
Wi
r
= Proportion of funds invested in ith Security
e
E(Ri) = Expected Return on ith Security
i v
n
n
= Number of securities in the portfolio
U
5.5.2 Portfolio Risk
L ,
S O
/
Portfolio risk is defined as the combined risk of all the securities that
L
are held in a portfolio. The variance (or standard deviation) is used to
O
measure the overall riskiness of a portfolio. For calculating the risk of a
C
/
portfolio, the weighted average of the standard deviation of each security
C E
is not taken into consideration rather covariance is used. The covariance
measures the interactive risk between the securities that form a portfolio.
D
In other words, covariance is a statistical measure of the co-movement
©D
between the security returns. It captures how the returns of two securities
move together.
The formula to calculate risk (variance) in a 2-security case i.e., X &
Y is as follows:
ıxy ¥wx2ıx2 + wy2ıy2 + 2wxwyCovxy
where,
ıp = Portfolio risk consisting of securities X & Y
wx = Percentage of total funds invested in Security X
PAGE 109
Notes wy = Percentage of total funds invested in Security Y

ıX = Standard deviation of the returns of Security X
ıY = Standard deviation of the returns of Security Y
CovXY = Covariance between security X & Y.
Like covariance, the correlation coefficient can also be used to capture
the co-movement in the expected returns of the securities. It is a relative
measure that is independent of the unit of measurement. The value of the
i
coefficient of correlation ranges between –1 to +1. If it is +1, returns of
h
e l
the portfolio securities are said to be perfectly positively correlated and
in the case of –1, the opposite movement in securities return is, thus,
said to be perfectly negatively correlated.
D
The formula is shown below:
of
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Covxy ȡxy ıx ıy
Alternatively,
s i
r
ȡxy = Covxyıx ıy
e
i v
ZKHUH ȡxy = Coefficient of correlation between securities X & Y.
U n
Hence, the formula to calculate risk (variance) in a 2-security case in
terms of the correlation coefficient is as follows:
L ,
ıxy ¥wx2ıx2 + wy2ıy2 + 2wxwy ȡxy ıx ıy
O
It is concluded from the above discussion that the expected return of the
S
L /
portfolio depends on the weight (or percentage) of total funds invested
in each asset and the return of each security. However, the portfolio risk
C O
depends on the weight (or proportion) of funds invested in available
E /
VHFXULW\ WKH ULVNLQHVV ı RI HDFK VHFXULW\ DQG WKH FRHIILFLHQW RI FRUUHODWLRQ
or covariance between the securities.
D C Example 1: The following information is given in respect of Security X
©D
and Security Y. Calculate portfolio risk and return if an investor invests
(i) 70% in X and 30% in Y
(ii) 50% in X and 50% in Y
(iii) 30% in X and 70% in Y
Security X Y
Expected Return 15% 9%
Standard Deviation 5% 3%
ȡxy between X and Y= –.85
110 PAGE
Solution: (i) When an investor invests 70% in X and 30% in Y Notes

Portfolio Return
n
E(Rp) = ∑ wi × E (Ri )
i =1
E(Rp) = .70 × 15 + .30 × 9

E(Rp) = 13.2%
Portfolio Risk
h i
e l
ıxy ¥ 2(5)2 + (.3)2(3)2 + 2(.7)(.3)(–0.85)(5)(3)
D
of
ıxy = 2.78%
ty
(ii) When an investor invests 50% in X and 50% in Y
Portfolio Return
s i
E(Rp) = .50 × 15 + .50 × 9
e r
E(Rp) = 12%
i v
Portfolio Risk
U n
,
L
ıxy
O
¥ 2(5)2 + (.5)2(3)2 + 2(.5)(.5)(–0.85)(5)(3)
S
ıxy = 1.46%
L /
O
(iii) When an investor invests 30% in X and 70% in Y
Portfolio Return
/ C
E
E(Rp) = .30 × 15 + .70 × 9
C
D
E(Rp) = 10.8%
©D
Portfolio Risk
ıxy ¥Zx2ıx2 Zy2ıy2 ZxZy ȡxy ıx ıy
ıxy ¥ 2(5)2 + (.7)2(3)2 + 2(.3)(.7)(–0.85)(5)(3)
ıxy = 1.14%
PAGE 111
Notes 5HODWLRQVKLS EHWZHHQ &RHIILFLHQW RI &RUUHODWLRQ

Portfolio Risk & Diversification
5.6.1 Relationship between Coefficient of Correlation &

Portfolio Risk
There is a direct relationship between portfolio risk and how closely
the returns of the securities that are held in a portfolio are related. If
h i
securities are less correlated, the portfolio risk will be lower and if
e l
D
they are highly correlated, the risk will be higher. If the returns of two
of
securities are perfectly correlated, uncorrelated or negatively correlated
affects the total risk of the portfolio can be explained with the help of
ty
a numerical given below:
s i
Example 2: Suppose an investor invests equally in two securities – X
e r
and Y. The risk and return of the securities are as follows: —
Security
i
E(R)
v ı
X
U n 22 4.9
,
Y 14 2
O L
Calculate and examine the portfolio risk if the coefficient of correlation
/ S
is –1, –0.2, 0, 0.2, 1.
O L
Solution: ,W VKRXOG EH QRWHG WKDW SRUWIROLR UHWXUQ ZLOO EH WKH VDPH
in all five cases.
/ C
Portfolio Return
CE
n
E(Rp) = ∑ wi × E (Ri )
D D i =1
©
E(Rp) = .50 × 22 + .50 × 14
E(Rp) = 18%
Portfolio Risk
ıxy ¥Zx2ıx2 Zy2ıy2 ZxZy ȡxy ıx ıy
112 PAGE
ıxy ¥ 2(1.9)2 + (.5)2(2)2 ȡxy(4.9)(2) Notes

ıxy ¥ ȡxy
&DVH ȡxy = –1
σ xy = √8.2025 + 4.9 ρ xy
= √8.2025 + 4.9 ( −1)

= 1.82
h i
&DVH ȡxy = -0.2
e l
σ xy = √8.2025 + 4.9 ρ xy
D
= √8.2025 + 4.9 ( − 0.2) of
i ty
s
= 2.69
&DVH ȡxy = 0
e r
σ xy = √8.2025 + 4.9 ρ xy
i v
= √8.2025 + 4.9 ( 0) U n
L ,
O
= 2.86
&DVH ȡxy = 0.2
/ S
σ xy = √8.2025 + 4.9 ρ xy
O L
= √8.2025 + 4.9 ( 0.2)
/ C
C E
D
= 3.03
©D
&DVH ȡxy = 1
σ xy = √8.2025 + 4.9 ρ xy
= √8.2025 + 4.9 (1)
= 3.62
PAGE 113
Notes Hence, the portfolio risk is minimum when the correlation coefficient
is perfectly negative. It increases with an increase in the coefficient of
correlation and becomes maximum when the returns on securities are
perfectly positively correlated.
5.6.2 Relationship between Coefficient of Correlation &

Diversification
The concept of diversification is based on the notion that if an investor
h i
e
invests his total funds in one place, there will be a possibility of high risk
l
D
in terms of incurring a heavy loss or losing the entire invested money if
of
that investment does not perform well. It is a method of minimizing risk
by investing in different investment options. The benefits of diversification
ty
can be reaped if the returns of the securities that are held in a portfolio
s i
are less than perfectly positively correlated. For diversification, we can say
e r
the lower the value of the correlation coefficient, the better it is for the
v
investor. Unsystematic risk can be avoided through diversification. When
n i
returns of two securities forming a portfolio are negatively correlated is
, U
termed hedging. However, when the coefficient of correlation is perfectly
negative i.e., –1, such securities are termed as hedge assets. The relationship
L
among diversification, correlation coefficient and portfolio risk has been
O
S
summarized below.
Coefficient of
L / Diversification Portfolio Risk
CO
correlation
UAB = + 1
/
No diversification or naive Portfolio risk is not reduced. Only
E
diversification. Risk averaging is there.
C
0 <UAB < l Diversification is possible. Portfolio risk can be reduced.
D D UAB = 0 Diversification is possible and

better than the previous case.
Portfolio risk can be further
reduced.
© –1<UAB<+0
UAB= –1
Not only diversification, but
hedging is also possible.
Perfect hedging is possible.
Portfolio risk will be lower.
Portfolio risk is least and it is

the case when 0 risk portfolio
is possible.
114 PAGE
5.7 Modern Portfolio Theories Notes
Every investor is risk-averse in the marketplace. However, they differ

in terms of their attitude towards risk and return. Some investors are
conservative while some are less conservative in terms of holding risk.
The same security may provide different levels of satisfaction or utility
to different investors depending upon the degree of risk possessed by a
particular investor. The main objective of every investor is to maximise
his utility scores by constructing an optimal portfolio which provides
h i
maximum return and minimizes the total risk of the portfolio. Now, the
e l
D
question is how to formulate an optimal portfolio. There are modern
of
portfolio theories such as Portfolio Theory, Capital Market Theory etc.
were proposed to select and construct a portfolio. The modern portfolio
y
theories have been explained in detail in the following sections.
i t
r s
5.7.1 Portfolio Theory: The Harry Markowitz Model
v e
i
The pioneering work of Harry Markowitz was published in an article
n
U
titled “Portfolio Selection” in the Journal of Finance in the year 1952.
,
The analytical and conceptual understanding to select an optimal portfolio
O L
by a rational investor has been provided in his seminal work. This theory
is popularly known as the Markowitz Model. This model is also known
/ S
as Mean-Variance Optimisation Model as it takes the risk and return of
L
different portfolios into consideration.
O
C
$VVXPSWLRQV IRU WKH +0 0RGHO DUH DV IROORZV

E /
An investor is risk-averse or conservative. He tends to avoid
C
unnecessary risks.
D
©D
Portfolio analysis is to be done based on risk and return.
An investor is rational. He would choose to invest in those securities
which provide him with maximum return with a minimum degree
of risk.
The decision for the selection of an optimal portfolio will be based
on means (returns) and variance (risk).
Every investor has different preferences towards risk & return. It
affects their utility scores resulting in their indifference curves
being different.
PAGE 115
Notes The financial markets are efficient, and investors have easy access to
all the available information related to returns, risk and coefficient
of correlation between the securities.
Based on the above assumptions, the HM model for portfolio selection
is explained in the following four steps:
h i
e l
D
of
i ty
r s
v e
n i
, U
O L
/ S
Figure 5.2: Steps in Optimal Portfolio Selection
O L
(a) Setting the Risk-Return Opportunity Set

/ CThe first step is to prepare an investment opportunity set. There
C E are ‘N’ numbers of securities available in the financial market. An

infinite number of possible portfolios can be made from the available
D securities in the market. An investor’s portfolio opportunity set shows
©D
the expected returns and risk is associated with all the possible
combinations that are formed from a set of available securities.
A large number of portfolios can be constructed even with two
securities by changing their weights only. For instance, 30% in X
and 70% in Y can be combined to formulate a portfolio, 88% in
X and 12% in Y to make another portfolio and all such possible
combinations can be made by two securities only. It is important to
116 PAGE
note that if the number of securities increases to 10 or 20 or 50 or Notes

maybe 100, the possible portfolios will also increase exponentially.
In Figure 5.3, there is a shaded region PVWP which is also known
as the investment opportunity region that shows the risk and returns
of all the possible sets of portfolios e.g., combination R represents
x1 level of risk and y1 level of return. Every point in this region
belongs to a particular portfolio.
h i
e l
D
of
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r s
v e
n i
U
Figure 5.3: Investment Opportunity Set in case of N securities

L ,
The region has many feasible portfolios in which an investor can
O
invest. Now, an investor has to choose whether he will invest in
S
portfolio P, which has a minimum degree of risk or in portfolio W,
L /
which provides maximum returns or some other portfolio, depending
O
upon the minimum return he expects from the investment concerning
/
his risk appetite.
C
E
(b) Determining the Efficient Set of Portfolios
C
D
Once the investment opportunity set is determined, the next step
©D
is to identify the efficient set of portfolios. An efficient portfolio
provides the maximum return for a given level of risk or has the
lowest possible degree of risk for a given level of return.
Rational investors always prefer more returns. In addition, since
they are risk-averse, they would prefer less risk. The efficient set
of portfolios will be subject to two prepositions:
Among all the possible portfolios providing an equal expected
return, an investor would always prefer the portfolio which
has the lowest degree of risk.
PAGE 117
Notes Among all the possible portfolios having the same degree of
risk, an investor would always prefer the portfolio which has
the highest expected return.
The set of efficient portfolios is known as Efficient Frontier. In
simple words, “Efficient Frontier is the graphical representation
of all the efficient portfolios out of the feasible portfolios”. All
efficient portfolios are feasible but all feasible portfolios are not
i
efficient due to their risk-return profile. In Figure 3, the points lie
l h
along the boundary PQSVW is called an efficient frontier. Portfolios
e
to the right of this boundary are not efficient because there would
D
be a greater risk for the given level of return. Also, portfolios at
of
lower levels of the boundary are not good as there would be fewer
returns for the given level of risk. It can be seen that portfolio S
ty
dominates all other portfolios lying below it.
s i
r
The reason is that all three portfolios i.e., S, T, & U are providing
e
the same degree of risk, x2 at different levels of returns. However,
v
n i
portfolio S has the highest return i.e., y2 at x2 level of risk and
hence, it is called an efficient portfolio.
, U
(c) Constructing Indifference Curves (IC) of the Investor

O L
Every investor wants to select an optimal portfolio to maximise his
S
utility or satisfaction. The indifference curve is used to analyse the
/
level of satisfaction of an investor. An indifference curve shows
L
O
an investor’s risk-return trade-off. Every investor is basically risk
C
averse; the indifference curve is upward-sloping for them. However,
E / the slope of the IC changes with the change in the risk preference
C
of the investor. The steeper the slope of the IC, the more risk-
D
averse the investor is while the flatter the slope of the IC, the less
©D
risk-averse the investor is. The main characteristic feature of an
investor’s utility curve is that they never intersect with each other
i.e., they are parallel.
118 PAGE
Notes
h i
Figure 5.4: Indifference curves of a risk-averse investor
e l
D
of
In Figure 5.4, an investor has three ICs, C1, C2 & C3. All the points
on a particular IC represent different levels of risk and return with
ty
the same amount of satisfaction. The utility on C1 is lowest and on
i
C3 is highest. Points S1 and S2 are on the same IC i.e., IC1 so they
s
r
provide the same amount of utility. If the satisfaction increases, an
e
v
investor will move to the higher IC i.e., IC2 and IC3. The higher
the IC, the more will be the utility.
n i
(d) Selecting the optimal portfolio
, U
L
The final step is to select the optimal portfolio. Every investor
O
aims to select the portfolio that maximises his utility. He wants
/ S
to attain the highest IC. However, the optimal portfolio is the one
L
where the IC of the investor must lie on the efficient frontier. In
O
simple words, the best portfolio selection will depend on the two
C
/
conditions that need to be satisfied:
E
The portfolio must lie on an efficient frontier and
C
D
The satisfaction of the investor is maximised.
©D
Figure 5.5 shows the selection process for the best portfolio. We
have placed the efficient frontier PRW on the indifference map. The
goal of the investor is to get the maximum utility. The indifference
curve C1 and C2 are attainable but inferior curves. An investor would
like to attain C3 but there are two portfolios lying on it i.e., R and
X, and both will provide him with the same level of satisfaction.
However, X is not able to meet one of the two conditions required
for the selection of an optimal portfolio. It is clearly shown in the
PAGE 119
Notes picture that X is not lying on the efficient frontier hence it is not
an efficient portfolio. We can say that the portfolio R would be
the best/optimal portfolio as it is on the efficient frontier as well
as providing the maximum level of satisfaction to the investor.
h i
e l
D
of
i ty
Figure 5.5: Selecting the Optimal Portfolio
r s
According to HM Model, the optimal portfolio for an investor is the
e
point of tangency where he will be able to get the maximum level of
v
i
satisfaction and also the best combination of risk and return.
n
U
Limitations of the HM Model
,
The model makes a rational attempt to identify the efficient portfolios
L
O
and then selection of optimal portfolios. However, the model suffers from
S
the following weaknesses:

L /
This model requires a large amount of input data to measure a
C O
portfolio’s risk and reward. If there are N securities in the portfolio,
/
then N estimates of return, N standard deviations, and N(N-1)/2
C E covariances are required. So, for 50 securities in a portfolio, we

want 50 returns, 50 standard deviations, and 50(50-1)/2, or 1225
D
©D
covariances. Hence total estimates required are 1325. For 100 securities,
we want 100 returns, 100 standard deviations, and 100(100-1)/2,
or 4950 covariances. Hence total estimates required are 5150. If
the number of securities increases in the portfolio to 100, then we
need total estimates of 1,25,750. Handling such a huge quantum
of data for analysis is cumbersome as well as a complex task.
As per this model, there are as many optimal portfolios as there
are several investors. However, this limitation is removed when we
introduce a risk-free asset in the capital market.
120 PAGE
5.7.2 Capital Market Theory Model Notes
The capital market theory is an extension of the Portfolio theory with

the addition of risk-free lending and borrowings. The existence of capital
market theory developed by Sharpe came into light when a research
paper titled “Capital Asset Price: A Theory of Market Equilibrium under
Conditions of Risk” was published in the Journal of Finance in 1964.
$VVXPSWLRQV IRU WKH &DSLWDO 0DUNHW 7KHRU\ DUH DV IROORZV
h i
l
Investors behave rationally i.e.; they are primarily assessing expected
to mean and variance to make investment decisions.
Securities are infinitely divisible.
D e
of

There are no limits on short sales/selling.
ty
There are a large number of investors and their buying or selling
behaviour does not affect the price of the security.
s i

e r
Frictionless markets i.e., no transaction costs or taxes are involved.

i v
In addition to risky assets, there are also non-risky/risk-free assets
in the market.
U n
,
Investors have uniform or identical expectations of returns, return
O L
variances and covariances for all the security pairs. This is an
important assumption for ensuring a unique efficient frontier.
/ S
O L
/ C
C E
D
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Figure 5.6: Capital Market Line
PAGE 121
Notes It is evident from Figure 5.6 that the efficient frontier is concave in shape.
The efficient frontier becomes a straight line when it originates from a
risk-free return on the Y axis and it happens when a risk-free security/
asset is introduced in the capital market. The new efficient frontier which
is a straight line is tangent to the original efficient frontier at point M.
This new straight-line frontier is called the capital market line.
The CML is given by the following equation:
( )
E ( Rp ) = R f +
σ p × ERm – R f
h i
σm
e l
D
where,
of
E(Rp) = expected return of a portfolio
Rf = risk-free rate of interest
i ty
E(Rm) = expected return on the market portfolio
r s
ıp = standard deviation of the portfolio
v e
i
ım = standard deviation of the market portfolio
U n
The capital market line shows that the expected portfolio return depends
upon the risk-free rate, per unit market return, and the overall risk of
L ,
the portfolio. In other words, the return of the portfolio is equal to the
O
risk-free rate plus a risk premium. The higher the risk, the higher will
/ S
be the expected return.
L
7KH FKDUDFWHULVWLF IHDWXUHV RI &0/ DUH DV IROORZV
O
C
CML indicates a positive linear relationship between portfolio risk
/
CE
(ıp) and expected return E(Rp).
The slope of CML is a risk-free rate because it originates from Rf.
D D The CML slope is the reward-to-variability ratio, measured as
©
[E(Rm) – Rf]/ım.
CML is tangent to the original efficient frontier at point M i.e., the
optimal portfolio of risky assets or the market portfolio.
Only efficient portfolios lie on CML consisting of risk-free assets
and portfolios of risky assets.
A risk-averse investor will never invest in a portfolio unless he
would get compensation for the risk. Hence, CML slopes upward
because the price of risk must be positive.
122 PAGE
It can be understood from Figure 5.7, if there will be no risk-free assets Notes
then the investor will select a portfolio that lies on the efficient frontier
depending upon his utility curve. However, with the inclusion of risk-
free assets, the investor can choose the portfolio on CML which is a
combination of risky and non-risky investments.
h i
e l
D
of
ty
Figure 5.7: Capital Market Line & Optimal Portfolio
s
Portfolios to the left side of the market portfolio, (i.e., M), are termed
i
r
as Lending Portfolios or Defensive Portfolios and they are suitable for
e
v
a more risk-averse investor. Portfolios to the right side of the market
n i
portfolio, (i.e., M), are termed as Borrowing Portfolios or Aggressive
U
Portfolios because they include risk-free borrowings. At point M (market
,
portfolio) borrowing or lending does not take place.
L
O
Example 3: The information of three portfolios is available to an investor:
/S
Portfolio E(R) ı
X
Y
O L 8%
20%
3%
10%
Z
/ C 17% 7%
C E
It is given that the risk-free interest rate is 4% and the estimated market
D
return is 12%. The market portfolio is having a risk of 5%. Find out
© D
whether these portfolios are efficient or not.
Solution: An efficient portfolio lies on CML. To check if these are efficient
portfolios, we have the calculate the expected return as per CML.
E ( Rp ) = R f +
(
σ p × ERm – R f )
σm
PAGE 123
Notes Portfolio E(R) (given) E(R) as per CML Efficient Portfolio or not
X 8% 4 + (12-4)3/5 = 8.8% Not Efficient
Y 20% 4 + (12-4)10/5 = 20% Efficient
Z 17% 4 + (12-4)7/5 = 15.2% Not Efficient
The estimated return of portfolio Y is equal to the return calculated as
per CML. So, this portfolio is efficient. It may be noted that portfolios X
& Z cannot persist in an efficient capital market. Here, Portfolio X has
i
an actual return (given as 8%) less than the returns estimated by CML,
l h
so it is an overpriced portfolio. Portfolio Z has an actual return (given
e
as 17%) higher than the returns estimated by CML, so it is underpriced.
D
5.7.3 Tobin’s Separation Theorem/Property f
o

i ty
Tobin’s Separation Theorem is based on the notion that decisions
s
related to financing and investment are separate. An investment
r
e
decision is to decide about investment in risky assets. A financing
i v
decision is to decide concerning to whether to lend or borrow.

U n
In CML, decisions related to both investment and financing are
,
independent of each other. According to the capital market theorem,
O L
investment decisions are the same for all the investors i.e., every
investor is investing in an optimal portfolio of risky assets i.e.,
/ S
portfolio M, also termed as market portfolio. On the other hand,
O L
in the case of financing decisions, different investors have different
preferences concerning lending or borrowing i.e., some prefer to
/ C lend while others prefer to borrow. Based on their risk preferences,
C E investors make a separate financing decision either to lend i.e., to
D
be on the left side of M or to borrow i.e., to be on the right side
D
of M to achieve their desired point on the CML.
© The separation theorem has important implications:

(a) Any asset or security which is not a part of a market portfolio
i.e., M cannot be able to exist in the market. Every investor
is investing in the market portfolio of risky assets i.e., M and
hence, there will be no takers of any other assets. In other
words, all the securities that are held in portfolio M will
survive in the capital market. Thus, portfolio M is termed a
market portfolio.
124 PAGE
(b) Every investor will invest in portfolio M, the only difference is Notes
the amount of investment. For example, assume that there are
two investors Mr. A and Z who wanted to invest Rs. 10,000
each in the market portfolio comprises of three securities P,
X and Y in the proportion of 10%, 20% and 70%. Mr. A is
conservative and therefore, decided to invest Rs. 8000 in the
portfolio of risky assets and the remaining Rs. 2000 to lend
at a risk-free rate. It implies that Mr. A will have Rs. 800
invested in security P, Rs. 1600 in X and Rs. 5600 in Y along
h i
with Rs. 2000 in risk-free assets. Let us assume that Mr. Z is
e l
D
an aggressive investor, thus, borrows Rs. 2000 at a risk-free
of
rate. So, he will have Rs. 12000 (i.e., 10000 + 2000) to invest
in portfolio M. It implies that the portfolio of Mr. Z consists
ty
of Rs. 1200 invested in security P, Rs. 2400 in security X
and Rs. 8400 in security Y along with a borrowing amount
s i
of Rs. 2000 at risk-free rate.
e r
i v
n
5.7.4 Capital Asset Pricing Model

, U
The concept of CAPM was discussed by Sharpe (1964), Lintner
O L
(1965) & Mossin (1966) independently in their research papers.
CAPM is an extension of Capital Market Theory which is used to
/ S
predict the expected return on a security or portfolio. The expected
L
return derived through CAPM can be used to ascertain if security is
O
C
earning more or not as compared to the expected return. From an
/
investor’s point of view, it is always desirable that their securities
E
C
provide higher returns than the one predicted by CAPM.

D
CAPM shows the direct relationship between the return required on
©D
VHFXULW\ DQG LWV V\VWHPDWLF ULVN GHQRWHG E\ ȕ 6LQFH WKHUH DUH WZR
types of risk i.e., systematic & unsystematic risk. The latter can
be diversified by constructing a portfolio while the former cannot.
Hence, as per this model, an investor must be rewarded for bearing
the systematic risk only.
CAPM is given by the following equation:
E ( Ri ) = R f + ⎡⎣⎢ E ( RM ) − R f ⎤β
⎦⎥ i
PAGE 125
Notes where,
E(Ri) = Expected return from security or asset
Rf = Risk-free rate of return
E(RM) = Expected return on a market portfolio
ȕi = Beta coefficient of security i, a measure of systematic
risk
i
According to CAPM,
Expected Return = Risk-free rate + Market risk premium
l h
In other words, it can be written as
D e
of
([SHFWHG 5HWXUQ 5HZDUG IRU 7LPH 5HZDUG IRU 5LVN
Example 4: Calculate the expected return for a security X using CAPM.
ty β
The required information is given below:
R f = 5% RM = 10%
s i
r
i = 0.70
v e
i
E(Rx) = Rf + [E(RM) – Rf ] ȕx
n
= 0.05 + (.10 – 0.05) × .70
U
,
= 0.085 or 8.5%
O L
It must be noted that there is a direct relationship between the estimated
S
returns of security and systematic risk. So, securities with high ȕ have
/
L
higher expected returns:

C O
The graphical representation of CAPM is done through the security
E / market line. It is a straight line which shows a linear relationship

between the expected return on security and the systematic risk.
D C The slope of SML is the market risk premium i.e., [E(RM) – Rf].
©D
As shown in Figure 5.8, all the fairly priced securities are plotted
on the SML. The assets above the line are undervalued because,
for a given amount of risk (beta), they earn a higher return. The
assets below the line are overvalued because, for a given amount
of risk, they earn a lower return.
126 PAGE
Notes
h i
e l
D
Figure 5.8: Security Market Line
of
Example 5: From the data given below, find out which of the securities
i ty
are underpriced or overpriced in terms of the SML equation:
r s
Security Actual Return (%)
v e Beta
P 8
n i 0.5
U
Q 24 2.0
,
R 22 1.6
S
T
15
20
O L 1.0
1.2
/ S
The return on the market index is 15% and the return on risk-free assets
is 6%.
O L
C
/E (R ) = R + E (R
Solution: As per SML,
CE
x f
⎡
⎣⎢ M ) − R f ⎤⎦⎥ β x
D D
Security Actual Return
(%)
Beta Return as per SML Underpriced/
Overpriced
P
Q
© 8
24
0.5
2.0
6
6
+
+
(15–6)
(15–6)
×
×
0.5
2
=
=
10.5
24
Overpriced
Fairly priced
R 22 1.6 6 + (15–6) × 1.6 = 20.4 Underpriced
S 15 1.0 6 + (15–6) × 1.0 = 15 Fairly priced
T 20 1.2 6 + (15–6) × 1.2 = 16.8 Underpriced
The actual return from the security P is less than the return calculated
as per SML, thus security P is overpriced and must be sold. However,
PAGE 127
Notes Security R and T, are underpriced and must be bought. In the case of
security Q and S, have actual returns equal to the CAPM return and
therefore, they are correctly priced.
5.7.5 Optimal Portfolio Construction Using Single Index

Model
The Single Index Model (SIM) was created in 1963 by William
i

h
F. Sharpe, who is best known for developing the Capital Asset
Pricing Model (CAPM), for which he received the Nobel Prize in
e l
D
Economics in 1990. Sharpe discovered that rather than calculating
of
the covariance (how two variables differ) or correlation (how two
variables are related) between every pair of stock returns, as proposed
ty
in the Markowitz model, this relationship can be found more simply
s i
through a market index (e.g., S&P 500 Index), reducing the number
e r
of calculations required in a portfolio analysis exercise.

i v
The SIM can be expressed, either in “raw returns” (i.e., ordinary
n
returns) or in “excess returns.”
U
,
The SIM formula when it is expressed in raw returns is shown below:
O L R i = Į i + ȕ iR m + İ i
S
where:
L /
Rit = total return of a stock or portfolio i
ȕi
O
= investment beta
C
E /
Rm = market portfolio return
C
Įit = time regression investment’s alpha
D İit = time regression residuals
©D
The SIM formula when it is expressed in excess returns is shown below:
(
Ri − R f = α i + β i Rm − R f + ε) i
where:
Rit = total return of a stock or portfolio i
ȕi = investment beta.
Rm = market portfolio return
128 PAGE
Rf = risk-free rate of return Notes

Įit = time regression investment’s alpha
İit = time regression residuals
It is important to note that Beta gauges systematic risk and shows the
firm’s sensitivity and reactivity to market index returns. A greater beta
coefficient indicates that the portfolio or security is riskier. A smaller
beta coefficient, on the other side, indicates less risk in the portfolio or
asset, which can be more advantageous for an efficient portfolio. Alpha
h i
l
tells us how much the asset or portfolio excelled or underperformed the
market index, adjusted for beta. Alpha shows the expected return on
security (over the risk-free rate) beyond any returns due to movements
D e
of
LQ WKH PDUNHW 5HVLGXDOV İ GHVFULEH KRZ PXFK RI WKH VHFXULW\ RU IXQG¶V
returns are being driven by random miscellaneous movements in the
i ty
market that cannot be explained by the asset-pricing model, also known
s
as “idiosyncratic volatility”. The residual represents the facts that are
r
e
driven by random firm-specific fluctuations rather than market returns
of the alpha on any particular day:
i v

U n
To elaborate, the SIM claims that a firm’s returns are determined
by a single factor, namely the market factor. In other terms, the
L ,
SIM asserts that a stock’s returns can be determined by its link to
O
a market index. This makes the SIM valuable when investors want
/ S
to learn how to predict a company’s returns on any given day. This
O L
distinguishes it from multifactor models, which assert that the firm’s
returns are the result of more than one factor.
IN-TEXT QUESTIONS
/ C
C E
3. ________describes the association between estimated return and
D
systematic risk for assets, particularly stocks.
©D
(a) PERT
(b) CAPM
(c) Sharpe ratio
(d) Treynor ratio
4. In Capital Market Line every investment is:
(a) Finitely divisible
(b) Infinitely divisible
PAGE 129
Notes (c) Both (a) & (b)

5. The main objective of a portfolio is to reduce _______ by
diversification.
(a) Return
(b) Risk
(c) Uncertainty
h i
(d) Percentage
e l
D
of
5.8 Solved Illustrations
ty
4XHVWLRQ$QLQYHVWRULVLQYHVWLQJLQVHFXULWLHV; <ZKRVHGHWDLOV
DUH JLYHQ EHORZ
s i
er
Security X Security Y
i v
E(R) 14.9% 20%
n
5LVN ı 10% 14.9%
, U
Weight (W) 50% 50%
L
The covariance between the returns of the securities is 100. Find out the
O
portfolio risk and return. Also, find the correlation between the returns
/ S
of X & Y.
L
Solution:
O
C
(a) Portfolio Return
E / E(R ) = ∑ w × E(R )p
n
i
C
i
i =1
D ( ) E R p = .50 × 14.9 + .50 × 20
©D ( ) E R p = 17.45%
(b) Portfolio Risk

ıxy = wx2ıx2 + wy2ıy2 + 2wxwyCovxy
ıxy = (0.5)2 (10)2 + (.5)2 (14.9)2 + 2(.5) (.5)100
ıxy = 11.42%
130 PAGE
(c) &RUUHODWLRQ EHWZHHQ WKH 5HWXUQV Notes

Covxy = ȡxy ıx ıy
100 = ȡxy (10) (14.9)
ȡxy = 0.67
Question 0U 3 LV LQYHVWLQJ LQ VHFXULWLHV ; < ZKRVH GHWDLOV DUH
JLYHQ EHORZ
i
E(R) 13% 15.5%
l h
ı
Weight
3.5%
40%
7%
60%
D e
of
Find out the expected return, minimum risk and maximum risk of the
ty
portfolio.
Solution:
s i
e r
( )
E R p = .40 × 13 + .60 × 15.5
i v
E ( R ) = 14.5%
U n
,
p
(b) Portfolio Risk

O L
/ S
&DVH 3RUWIROLR KDV PLQLPXP ULVN ZKHQ ȡxy = -1
L
ıxy = wx2ıx2 + wy2ıy2 + 2wxwy ȡxy ıx ıy
O
C
ıxy = (0.4)2 (3.5)2 + (.6)2 (7)2 + 2(.4) (.6) (–1) (3.5) (7)
E /
ıxy = 2.8%
C
&DVH 3RUWIROLR KDV PLQLPXP ULVN ZKHQ ȡxy = +1
D
©D
ıxy = (0.4)2 (3.5)2 + (.6)2 (7)2 + 2(.4) (.6) (1) (3.5) (7)
ıxy = 5.6%
4XHVWLRQ 7KH LQIRUPDWLRQ RQ VHFXULW\$ DQG % LV DYDLODEOH EHORZ
Security A Security B
E(R) 20% 25%
5LVN ı 10% 15%
Weight (W) 70% 30%
PAGE 131
Notes The covariance between the returns of the securities is 100. Find out the
portfolio risk and return.
Solution:
n
E ( R p ) = ∑ wi × E ( R i )
i =1
( )
E R p = .70 × 20 + .30 × 25
h i
E ( R ) = 21.5%
p
e l
D
of
(b) Portfolio Risk
ıxy = wx2ıx2 Zy2ıy2 + 2wxwyCovxy
i ty
ıxy = (0.7)2 (10)2 + (.3)2 (15)2 + 2(.70) (.30) (100)
ıxy = 10.55%
r s
v e
4XHVWLRQ7KHH[SHFWHGUHWXUQDQGULVNRI; <DUHJLYHQEHORZ
ni
E(R)
ı
, U 10%
20%
12%
25%
O L
The coefficient of correlation between the returns of two securities is
/ S
0.7. An investor has to decide about the portfolio of X & Y as 65% +
O L
35% or 35% + 65%. Which one should he accept?
Solution:
/ C
E
For 65% + 35% portfolio of X & Y:
D C ( ) E R xy = W X R X + WY RY
© D ( ) E R xy = .65 × 10 + .35 × 12
( ) E R xy = 10.7%
σ xy = √ ( 0.65) ( 20) + (.35) ( 25) + 2 (.65)(.35)( 0.7)( 20)( 25)
2 2 2 2
ıxy = 20.12%
132 PAGE
For 35% + 65% portfolio of X & Y: Notes
( )
E R xy = W X R X + WY RY
E ( R ) = .35 × 10 + .65 × 12
xy
( )
E R xy = 11.3%
ıxy = √ ( 0.35) ( 20) + (.65) ( 25) + 2 (.35)(.65)( 0.7)( 20)( 25)
h i
l
2 2 2 2
ıxy = 21.72%
D e
of
The portfolios of both securities are having different expected returns and
risks. An investor will choose the one which is less risky by calculating
the coefficient of variation.
i ty
CV ıxy/R
r s
= 20.12 /10.7
v e
= 1.88
n i
CV
,
ıxy/R U
L
= 21.73 /11.3
O
/ S= 1.92
O L
It is concluded that the investor should prefer the portfolio having weights
C
65% + 35% respectively. The CV of the another one is higher making
E
it a risky investment.
/
C
4XHVWLRQ7KHH[SHFWHGUHWXUQDQGULVNRI0 1DUHJLYHQEHORZ
D
©D
Security M Security N
E(R) 20% 15%
ı 15% 8%
The coefficient of correlation between the returns of two securities is 0.7.
An investor has to decide about the portfolio of X & Y as 75% + 25%.
PAGE 133
Notes Solution:
Portfolio Return
( )
E R xy = W X R X + WY RY
E ( R ) = .75 × 20 + .25 × 15
xy
( )
E R xy = 18.75%
h i
l
Portfolio Risk
ıxy = w ıx + wy ıy + 2wxwy ȡxy ıx ıy
x
2 2 2 2
D e
of
σ xy = √ ( 0.75) (15) + (.25) (8) + 2 (.75) (.25) ( 0.7) (15) (8)
2 2 2 2
ty
ıxy = 12.73%
s i
Question 6: The information of three portfolios is available to an
investor:
e r
Portfolio
i v E(R) ı
X
Y
U n 28%
22%
30%
16%
Z
L , 17% 10%
O
It is given that the risk-free interest rate is 10% and the estimated market
S
L /
return is 19%. The market portfolio is having a risk of 12%. Comment
on whether these portfolios are efficient or not.
C O
Solution: An efficient portfolio lies on CML. To check if these are
E /
efficient portfolios, we have the calculate the expected return as per CML.
( )
D C ( )
E Rp = R f +
σ p × ER m – R f
σm
©D Portfolio
X
E(R) (given)
28%
E(R) as per CML
10 + (19–10)30/12 = 32.5%
Efficient Portfolio or not
Not Efficient
Y 22% 10 + (19–10)16/12 = 22% Efficient
Z 19% 10 + (19–10)10/12 = 17.5% Not Efficient
The estimated return of portfolio Y is equal to the return calculated as
per CML. So, this portfolio is efficient. It may be noted that portfolios
X & Z cannot persist in an efficient capital market. Here, Portfolio X
134 PAGE
has an actual return (given as 28%) less than the returns estimated by Notes
CML, so it is an overpriced portfolio. Portfolio Z has an actual return
(given as 19%) higher than the returns estimated by CML, so it is an
underpriced portfolio.
Question 7: The risk-free rate of interest is 7% and the return on
the market portfolio is 17%. The risk of the market portfolio is 5%.
An investor has constructed a portfolio having a risk of 10%. Find
i
out the expected return as per CML.
Solution:
l h
( )
E Rp = R f +
(
σ p × ER m – R f )
D e
of
σm
ty
(17–7) × 10
= 7 +
5
s i
= 7 + 20
e r
= 27%
i v
U n
Question 8: The risk-free rate is 7% and the market risk premium is
12% and the beta of the security is 1.3. What is the expected return
of the security under CAPM?
L ,
Solution:
S O
/
E ( R x ) = R f + ⎡⎣ E ( R M ) − R f ⎤⎦ β x
L
/ CO = 7 + (12) × 1.3
C E = 22.6%
D
Question 9: The risk-free rate is 7%. The ȕ of the security and the
© D
market return of the portfolio is 0.7 & 18% respectively. Calculate
the expected rate of return of the security and also calculate ȕ of the
VHFXULW\ ZKLFK KDV DQ H[SHFWHG UHWXUQ RI
Solution: E(R) = Rf + [E(RM) – Rf] ȕ
= 7 + (18 – 7) × 0.7
= 14.7%
PAGE 135
Notes ȕ RI WKH VHFXULW\ ZKLFK KDV DQ H[SHFWHG UHWXUQ RI
E(R) = Rf + [E(RM) – Rf] ȕ
20 = 7 + (18 – 7) × ȕ
ȕ = 1.18
4XHVWLRQ )LQG RXW WKH H[SHFWHG UHWXUQ RI WKH IROORZLQJ VHFXULWLHV
if the prevailing interest rate on Govt. securities is 7% and the rate
RI UHWXUQ RQ WKH PDUNHW LQGH[ LV 7KH EHWD IDFWRU RI VHFXULW\$
% & ' DUH UHVSHFWLYHO\
h i
Solution:
e l
E(R) = Rf + [E(RM) – Rf] ȕ
D
Expected Return for Security A
of
ty
= 7 + (10–7) × 1
= 10%
s i
Expected Return for Security B
e r
i v
= 7 + (10–7) × 1.25
U n = 10.75%
L ,
Expected Return for Security C
S O = 7 + (10–7) × 1.70
L / = 12.10%
O
Expected Return for Security D
/ C = 7 + (10–7) × 1.50
CE
= 11.50%
D D 5.9 Summary
© An investor never chooses to invest all of his savings in an individual

security/asset. Rather, any investor needs to invest in a variety of financial
securities simultaneously. It is an attempt to diversify and minimize
risk, hence, the loss in one security will be compensated by the gain
in others. Portfolio management involves the process of formulation,
maintenance, revision and continuous evaluation of a portfolio. It starts
with portfolio analysis which evaluates the efficiency of different portfolios
136 PAGE
in the context of the risk and return profile of each possible portfolio. Notes
Then, modern portfolio theories i.e., Harry Markowitz Model, Capital
Market Theory, Separation theorem and single index model are discussed
in the literature and have been used by an investor to select an optimal
portfolio. Portfolio management is an ongoing process, that requires
continuous monitoring of the portfolio to keep track of any changes
that take place concerning risk and return profile and price levels of the
individual securities with the change in the financial environment which
in turn brings a change in the portfolio risk and return profile. Finally,
h i
the evaluation of a portfolio is the last step as well as an integral part
e l
D
of the portfolio management process. Portfolio evaluation is crucial to
of
determine whether the selected efficient portfolios have been reaping the
desired return or not.
i ty
s
$QVZHUV WR ,Q7H[W 4XHVWLRQV
e r
v
1. (b) Portfolio
2. (c) Both (a) & (b)
n i
3. (b) CAPM
, U
4. (b) Infinitely divisible
O L
S
5. (b) Risk
L /
O
/ C
E
1. What do you understand by the term portfolio? How do you measure
C
the portfolio risk and return for a two-security portfolio?
D
2. What is Portfolio Management? Explain the steps involved in
©D
managing the portfolio.
3. Explain the concept of coefficient of correlation in the construction
of a portfolio.
4. What is an efficient portfolio in the context of the HM Model?
5. Critically examine Portfolio Theory along with its assumptions and
limitations.
6. Explain the characteristics of the Capital Market Line.
PAGE 137
Notes 7. Differentiate Security Market Line and Capital Market Line.

8. Explain the concept of the Separation Theorem.
9. Explain the Capital Asset pricing model along with its assumptions
and limitations.
10. Explain the concept of optimal portfolio construction using Single
Index Model.
11. State True or False –
h i
(a) A risk-averse investor always opts for the asset with the higher
e
estimated return, when two assets have the same risk.
l
D
(b) The Technical Approach for security analysis deals with
of
historical trends and patterns to estimate the price of securities.
ty
(c) Diversification removes the risk completely.
i
(d) Covariance measures the variability in a particular stock’s
s
return.
e r
v
(e) The coefficient of correlation should be either +1 or –1.
n i
(f ) HM model deals with the evaluation of a portfolio.
U
(g) Efficient Frontier consists of a large number of efficient
,
L
portfolios.
O
(h) SML and CML have the same shape and are based on the same
S
/
notion.
L
O
(i) If a portfolio lies below CML, it is not efficient.
/ C (j) According to the Separation Theorem, investment and financing
E
decisions are not independent of each other.
D C (Ans. (a) T, (b) T, (c) F, (d) T, (e) F, (f) F, (g) T, (h) F,

(i) T, (j) F)
©D
12. Write short notes on the following:
(a) Systematic Risk
(b) Diversification
(c) Beta Factor
(d) Unsystematic Risk
(e) Capital Market Theory
(f) Portfolio Risk
138 PAGE
13. Harsh has 78% of his funds invested in Security A and 22% in Notes
Security B. The expected risk & return associated with Security
A are 9.82% and 16.32% respectively. In the case of Security B,
the expected return & risk are 14.97% and 32.86%. What is the
portfolio’s expected risk and return respectively?
(Ans. – Portfolio return = 10.95%, Portfolio risk = 15.13%)
14. Mr. Pranav has two securities for his portfolio whose details are
i
given below:
l h
E(R) 15% 19%
D e
of
ı 5% 7%
If he invested 40% in X and 60% in Y, find the expected return,
ty
maximum and minimum risk of such portfolios.
s i
(Ans. - Portfolio Return = 17.4%, Maximum Risk = 6.2%, Minimum
Risk = 2.2%)
e r
i v
15. The expected return and risk of P & Q are given below:
Security P
U n Security Q
E(R)
ı
20%
15%
L , 15%
8%
S O
/
The coefficient of correlation between the returns of two securities
L
is 0.3. An investor has to decide about the portfolio of X & Y as
75% + 25%.
C O
/
(Ans. - Portfolio Return = 18.75%, Risk = 12%)
E
C
16. An investor has two stocks: S and T. The risk is 0.25 for S and
D
0.14 for T. The correlation between the two securities is 0.1285.
©D
Calculate the covariance between the returns of S and T.
(Ans. – CovarianceST = 0.0045)
17. An investor has two stocks: A and B. The risk is 30% for A and
20% for B. The covariance between the returns of A and B is 0.01.
Calculate the coefficient of correlation.
(Ans. - ȡAB = 0.167)
PAGE 139
Notes 18. The risk and return of the market portfolio are 28% and 14%
respectively. The risk-free rate is 10% and the standard deviation
of the portfolio is 37%. Find out the expected return of the investor
as per CML.
(Ans. - E(Rp) = 15.28%)
19. The risk-free rate is 8%. The ȕ of the security and the market
return of the portfolio is 0.7 & 16% respectively. Calculate the
i
expected rate of return of the security and also calculate ȕ of the
other security that has an expected return of 24%.
l h
(Ans. - E(Rs) = 13.6%, ȕ = 2)
D e
of
20. From the data given below, find out which of the securities are
underpriced or overpriced in terms of the SML equation:
ity
Security E(R) Beta
A
r s
15 1.9
e
B 25 3
C
i v 18 1.2
U
D
E n 10
15
0.5
1.6
L ,
The return on the market index is 12% and the return on risk-free
O
assets is 8%.
S
L /(Ans. – A is overpriced, B, C & E are underpriced, and D is fairly
O
priced)
/ C
E
5.12 References
D C Baldridge, R. (2023). Understanding Modern Portfolio Theory. Forbes
©D
$'9,625 Retrieved from: https://www.forbes.com/advisor/investing/
modern-portfolio-theory/
McClure, B. (2022). Modern Portfolio Theory: Why It’s Still Hip.
Investopedia. Retrieved from: https://www.investopedia.com/managing-
wealth/modern-portfolio-theory-why-its-still-hip/
140 PAGE
Rustagi R.P. (2021). Investment Management: Theory and Practice. Notes

New Delhi: Sultan Chand & Sons.

i
h
Delhi: McGraw-Hill Education.
e l
D
of
ty

s i
e r
i v
U n
L ,
S O
L /
C O
E /
D C
©D
PAGE 141
L E S S O N
6
Asset Pricing
Anil Kumar
Assistant Professor
Shri Ram College of Commerce
University of Delhi
h i
STRUCTURE
e l
D
of
6.2 Introduction
6.3 Capital Assets Pricing Model (CAPM)
i ty
6.4 Extensions to the CAPM
r s
6.5 Arbitrage Pricing Theory
v e
6.6 Active Portfolio Management
n i
6.7 Summary
, U
6.8 Illustrations
O L
S
L /
6.11 References
C O
/
E
D C

©DUnderstand the Standard Capital Asset Pricing Model (CAPM).

Explore Extensions of the Capital Asset Pricing Model.
Familiarize with Arbitrage Pricing Theory (APT).
Develop knowledge of Active Portfolio Management.
142 PAGE
ASSET PRICING
Understanding asset pricing is crucial for investors, portfolio managers,

and financial analysts in the dynamic world of finance and investment.
To successfully negotiate the complexity of precisely pricing financial
assets, one must have extensive knowledge and cutting-edge methodologies
of the capital markets. The depths of asset valuation are explored in
this chapter, which also examines the underlying ideas and models that
influence the current investment environment.
h i
We set out on a quest to solve the secrets of asset pricing within the
e l
D
pages of this in-depth manual, building on the basis provided by the
of
Standard Capital Asset Pricing Model (CAPM). A pillar of contemporary
finance, the CAPM provides a place to begin understanding the connection
ty
between risk and return in the context of diversified portfolios. We will
s
look at the CAPM’s presumptions, computations, and implications in
i
r
order to provide readers with a clear knowledge of both its advantages
e
v
and disadvantages.
n i
We go into the CAPM’s extensions in order to look beyond its original
U
confines. It is crucial to investigate more complicated frameworks that
,
L
capture additional elements impacting asset values as the capital markets’
O
complexity increases. This chapter examines various CAPM extensions,
/ S
such as multifactor models that include elements like size, value, and
L
momentum. We thoroughly analyse these extended models to reveal
O
their strengths and weaknesses, giving readers a complete set of asset
appraisal tools.
/ C
C E
The Arbitrage Pricing Theory (APT) emerges as a significant alternative
pricing model in addition to the CAPM and its extensions. The APT,
D
©D
created by Stephen Ross, provides a distinctive viewpoint on asset pricing
by identifying macroeconomic variables that affect security returns. The
reader will learn a lot about the APT’s assumptions, applications, and
empirical data as we navigate its complexities. Readers may properly
analyse and compare these two well-known asset pricing theories and
make wise investing decisions by learning both the CAPM and the APT.
Investors and portfolio managers must understand the idea of active portfolio
management in order to successfully traverse the dynamic world of asset
PAGE 143
Notes pricing. In-depth analysis of active portfolio management strategies is

provided in this chapter, which looks at strategies such stock selection,
market timing, and risk management. Readers will have a thorough
understanding of the subtleties and difficulties of active management,
enabling them to put into practise successful investment strategies by
drawing on the huge body of research and practical insights.
This chapter combines theoretical underpinnings with practical applications,
i
using a hands-on approach to ensure applicability in real-world settings.
l h
The use of case studies, numerical examples, and empirical research will
e
give readers a comprehensive understanding of asset pricing. We place a
D
strong emphasis on the value of data analysis, quantitative methods, and
of
critical thinking in order to efficiently assess and make wise financial
decisions.
i ty
Students, scholars, financial professionals, and anybody else looking to
r s
get a deeper grasp of asset valuation will all benefit from Unit V: Asset
e
Pricing. The information is organised logically and methodically, laying a
v
n i
solid foundation of understanding before exploring more complex subjects.
This strategy makes sure that readers with different levels of competence
U
can make use of the information and advance at their own speed.
,
O L
In summary, the goal of this chapter is to provide readers with the information
and resources they need to successfully negotiate the intricate world of
/ S
asset pricing. Readers will get a thorough understanding of asset valuation
O L
by investigating the Standard Capital Asset Pricing Model, its extensions,
the Arbitrage Pricing Theory, and active portfolio management strategies.
/ C
Unit V: Asset Pricing will be a vital tool on your path to mastering asset
C Epricing, whether you are a student of finance, an experienced professional,
D
or an individual trying to improve your financial knowledge.
©D 6.3 Capital Assets Pricing Model (CAPM)

One of the biggest advancements in portfolio theory is the capital asset
pricing model. The model is straightforward yet effective; it is clear
but profound. William Sharpe, John Lintner, Jack Treynor, and Jan
Mossin all independently developed the CAPM, which expands on Harry
Markowitz’s prior research on diversification and contemporary portfolio
theory. Given the beta of an asset, the model gives a linear anticipated
144 PAGE
ASSET PRICING
return-beta connection that exactly calculates the expected return. This Notes
shifts the focus from overall risk to systematic risk, which is the main
driver of projected return. Remember the following formula:
E(Ri) = Rf + ȕi[E(Rm) – Rf]
According to the CAPM, the only factor that affects an asset’s expected
returns is its systematic risk, which is determined by beta. Regardless of
the characteristics of the assets, two assets with the same beta will have
i
the same expected return. All assets are solely defined by their beta risk
due to the link between risk and return, which we will explain when we
l h
go over the underlying assumptions.
D e
of
Assumptions of the CAPM
By using simple assumptions, the CAPM, like all other models, ignores
ty
many of the intricacies of financial markets. Without adding complexity
s i
to the investigation, these assumptions enable us to get crucial insights
r
into how assets are valued. We can loosen the assumptions once the
e
v
fundamental relationships have been discovered and then consider how
n i
our insights might need to be modified. Some of these presumptions are
U
restrictive, while others are constructive. Additionally, some hypotheses only
,
slightly or exclusively affect a specific group of assets or relationships:
L
O
1. Investors are risk-averse, utility-maximizing, rational individuals:
S
Investors that are risk-averse anticipate receiving compensation
L /
for taking on risk. It should be noted that the assumption merely
O
needs that investors be risk averse; it does not demand that they
/ C
be equally risk averse. According to utility maximisation, investors
E
constantly desire more wealth (i.e., they are never satisfied) and
D C
prefer higher returns over lower returns. It is assumed that investors
make rational judgements because they accurately assess and analyse
©D
the information at hand. Although rational investors may arrive at
various estimates of expected risk and expected profits using the
same information, homogeneity among investors (see Assumption
4) necessitates that investors be reasonable people.
Most people agree that utility maximisation and risk aversion reflect
a realistic perspective on the world. However, investors may allow
their own prejudices and experiences to interfere with their decision-
making, leading to unfavourable investments, and raising questions
PAGE 145
Notes about investor rationality. However, as long as it does not significantly

alter prices (i.e., the trades of irrational investors cancel each other
out or are outweighed by the transactions of rational investors), the
outcomes of the model are unaffected by such illogical behaviour.
2. Markets are frictionless, including no transaction costs and no
taxes: We can separate the analysis from the way that markets
function thanks to frictionless markets. By doing this, we prevent
i
factors like the volume of trade on the New York Stock Exchange
or the spread between the asking and closing prices from having
l h
e
an impact on the risk-return relationship. Particularly, there are no
D
transaction fees, taxes, or limitations on short sales in frictionless
of
marketplaces. We also believe it is conceivable to lend and borrow
at a risk-free rate.
i ty
Many major institutions have little transaction costs, and many of
r s
them do not pay taxes. Even non-zero transaction costs, taxes, or
e
the inability to borrow money at risk-free rates have no discernible
v
n i
impact on the CAPM’s overall findings. However, costs associated
with short selling or prohibitions on short selling may result in an
U
upward tilt in asset prices, thus jeopardising the validity of key
,
L
CAPM findings.
O
3. Investors plan for the same single holding: All investment decisions
S
L /
are based on the single period of the CAPM, which is a single-
period model. Because working with multi-period models is more
O
challenging, the assumption of a single period is used for convenience.
C
E / However, learning cannot take place in a single-period paradigm,
and poor choices may continue. Furthermore, decisions made
D C in some periods that may appear suboptimal when seen from a
©D
single-period viewpoint may be necessary to maximise utility at
the end of a multi-period horizon. The single holding period does
not significantly restrict the CAPM’s applicability to multi-period
contexts, though.
4. Investors have homogeneous expectations or beliefs: According to
this supposition, every investor evaluates securities the same way,
applying the same probability distributions and future cash flow
inputs. The investors will also reach the same valuations given
that they are sensible beings. They will produce the same ideal
146 PAGE
ASSET PRICING
risky portfolio, which we refer to as the market portfolio because Notes

they value all assets the same way. As long as the variations in
expectations do not considerably produce distinct optimal risky
portfolios, the premise of homogeneous beliefs can be ignored.
5. All investments are infinitely: According to this presumption, a
person may invest in an item in any amount they choose, no matter
how little or how big. As a result of this premise, the model can
i
rely on continuous functions rather than discrete jump functions. The
assumption is only for convenience and has no bearing whatsoever
l h
e
on the model’s conclusions.
6. Investors are price: The CAPM makes the assumption that there are
D
of
several investors, none of whom are large enough to have an impact
on prices. Investors are price takers, thus we believe that trades
i ty
by investors have little impact on security prices. This assumption
r s
is typically accurate because, despite the possibility that investors
e
could influence the prices of small stocks, those stocks are typically
v
i
too small to have an impact on the CAPM’s pricing outcomes.
n
U
These presumptions are primarily intended to produce a marginal investor
,
who makes predictable mean-variance-efficient portfolio selections.
O L
From a functional and informational standpoint, we assume away any
market inefficiencies. Even though some of these hypotheses might seem
/ S
implausible, most of them can be relaxed with little to no impact on the
O L
model’s performance and predictions. In addition, the CAPM offers a
standard for comparison and for generating preliminary return projections,
/ C
despite all of its flaws and shortcomings.
C E
Question 1: Assume that the market portfolio’s expected return is 13% and
D
that its standard deviation is 23%. The risk-free rate is 3%. Bajaj Auto,
©D
an Indian business, deviates from the market by a standard deviation of
50%. Determine the beta and projected return for Bajaj Auto.
Solution:8VLQJWKHIRUPXODIRUȕiZHFDQFDOFXODWHȕi and then the return.
ȡi,m ıi 0.0 × 0.50
ȕi = =
ım 0.23
= 0
E(Ri) = Rf ȕi[E(Rm) – Rf] = 0.03 + 0 × (0.13 – 0.03) = 0.03 = 3.0%
PAGE 147
Notes Bajaj Auto’s beta is zero because it has no association with the market
portfolio. The predicted return for Bajaj Auto is the risk-free rate, which
is 3%, as the beta is zero.
Question 2: Assume that the market portfolio’s expected return is 13%
and that its standard deviation is 23%. The risk-free rate is 3%. Mueller
Metals, a German business, has a market correlation of 0.65 and a
standard deviation of 50%. Determine the beta and expected return for
i
Mueller Metal.
l h
Solution: 8VLQJWKHIRUPXODIRUȕiZHFDQFDOFXODWHȕi and then the return.
βi=
ρ i ,mσ i 0.65 × 0.50
σm
=
D e
of
0.23
=1.41
i ty
E(Ri) = Rf ȕi[E(Rm) – Rf] = 0.03 + 1.41× (0.13 – 0.03) = 0.171 = 17.1%
r s
Because Mueller Metals and the market have such strong correlations,
v e
the company’s beta is 1.41 and its predicted return is 17.1%. Mueller
n i
Metals has an expected return that is higher than the expected return of
U
the market because its systematic risk is higher than the market.
L ,
Question 3: Current expected risk-free return is 4%, the asset’s beta
is 1.40, and the equity risk premium is 4.6%, then calculate the asset’s
required return.
S O
L /
Solution: Required return on the share i = Current expected risk-free
O
UHWXUQ ȕi (Equity risk premium)
C
E /
= 0.040 + 1.40(0.046) = 0.1044
C
= 10.44%
D Limitations of the CAPM
©D
There are theoretical and practical restrictions on the CAPM. Practical
limits are those that develop from applying the model, whereas theoretical
limitations are those that are inherent in the model’s construction.
Theoretical Limitations of the CAPM
Single-factor model: The CAPM only prices systematic or beta risk.
As a result, the CAPM specifies that while evaluating returns, no
additional investment characteristics should be taken into account.
148 PAGE
ASSET PRICING
As a result, despite being quite restrictive, it is prescriptive, simple Notes

to understand, and apply and
Single-period model: The CAPM is a single-period model that
does not take into account the consequences for many periods or
the investment goals of subsequent periods, which might result in
myopic and unfavourable investment choices. For instance, it can be
best to skip an interest payment in order to maximise returns in the
i
now, but doing so might have unfavourable effects in the future. It
is impossible for a single-period model like the CAPM to account
l h
e
for factors that change over time and span multiple periods.
Practical Limitations of the CAPM
D
Implementing the CAPM raises a number of practical issues in addition
of
ty
to the theoretical ones, some of which are described below:

s i
Market portfolio: According to the CAPM, the actual market portfolio
r
contains all assets, both financial and nonfinancial, including many
e
v
that cannot be invested, such as human capital and assets in closed
n i
economies. The genuine market portfolio is not observable, as
U
Richard Roll pointed out, which is one of the reasons the CAPM
cannot be tested.
L ,
O
Proxy for a market portfolio: Market players typically employ proxies
S
when there isn’t a real market portfolio. However, these proxies
L /
produce varying return estimates for the same asset depending on
O
the analyst, the investor’s nation, etc., which is not allowed by the
CAPM.
/ C

C E
Estimation of beta risk: To calculate beta risk, a lengthy history of
returns (three to five years) is needed. However, the historical state
D
of the corporation might not be a reliable indicator of its present or
©D
future state. The CAPM is an ex ante model more generally, however
it is typically used using ex post. Additionally, different estimates
of beta are obtained when utilising various estimation periods. For
example, A beta estimated with daily returns is unlikely to be the
same as a beta estimated with monthly returns, and a three-year
beta is unlikely to be the same as a five-year beta. As a result,
depending on the beta risk estimate that is utilised in the model,
we may estimate various returns for the same asset.
PAGE 149
Notes If the CAPM were a good model, its estimate of asset returns would
be highly correlated with realised returns.
The CAPM receives little empirical evidence, nevertheless. To put it
another way, analyses of the CAPM demonstrate that asset returns are not
solely influenced by systematic risk. Because return-generating models
are employed to anticipate future returns, the CAPM has a severe flaw
in that returns are not predictably predictable.
i
Homogeneity in investor expectations: For the CAPM to produce a
l h
single ideal risky portfolio (the market) and a single securities market
D e
line, homogeneity in investor expectations must exist. There will be many
ideal risky portfolios and many security markets without this supposition.
of
It is obvious that investors can rationally analyse the same information
and arrive at various optimal risky portfolios.
IN-TEXT QUESTIONS
i ty
r s
e
1. The CAPM assumes that investors are:
(a) Risk-averse
i v
(b) Risk-neutral
U n
,
(c) Risk-seeking
L
O
/ S
2. The CAPM states that the expected return of an asset is equal
L
to:
CO
(a) The risk-free rate plus the beta of the asset multiplied by
E / the market risk premium
C
(b) The risk-free rate plus the alpha of the asset
D D (c) The beta of the asset multiplied by the market risk

premium
© (d) None of the above
6.4 Extensions to the CAPM

It is not unexpected that different models have been presented to alleviate
some of the CAPM’s shortcomings given their shortcomings. As we analyse
the models, we will note that these new models have some limits of their
150 PAGE
ASSET PRICING
own. We categorise the models into two groups: theoretical models and Notes
practical models.
Theoretical Models
Theoretical models have a similar foundation as the CAPM but include
more risk elements. Stephen Ross’s creation, the arbitrage pricing theory
(APT), is the best illustration of a theoretical model. APT suggests a
linear relationship between expected return and risk, similar to the CAPM:
E(Rp) = RF Ȝ1ȕp,1 ȜKȕp,K
h i
where
e l
E(Rp) = the expected return of portfolio p
D
of
RF = the risk-free rate
ty
Ȝj = the risk premium (expected return in excess of the risk-free
rate) for factor j
s i
ȕp,j = the sensitivity of the portfolio to factor j
e r
K = the number of risk factors
i v
U n
APT, on the other hand, permits a wide range of risk factors—as many as
are pertinent to a certain asset—in contrast to the CAPM. In addition, risk
L ,
variables need not be universal and may differ from one asset to another,
O
aside from the risk-free rate. The risk components are identified and their
/ S
betas are estimated using a no-arbitrage condition in asset markets.
O L
APT does not specify any of the risk factors, making it challenging to
identify risk factors and calculate betas for each asset in a portfolio, despite
/ C
the fact that it is theoretically more elegant, flexible, and superior to the
E
CAPM. As a result, it is not frequently employed in practise. Therefore,
C
D
the CAPM is recommended over the APT from a practical aspect.
©D
Practical Models
Which factors, if any, account for returns if beta risk in the CAPM does
not? Practical models use in-depth study to try to provide an answer to
this query. As stated in Section 3.2.1, the four-factor model proposed by
Fama and French (1992) and Carhart (1997) is the greatest illustration
of such a model.
Fama and French (1992) claimed that three components appear to
explain asset returns more effectively than just systematic risk based on
PAGE 151
Notes an investigation of the link between past returns and a range of various
factors. These three elements include the asset’s beta, relative size, and
relative book-to-market value. The model can be expressed as follows by
including the relative previous stock returns introduced by Carhart (1997):
E(Rit) = Įi + ȕi, MKT MK Tt + ȕi, SMB SM Bt + ȕi, HML HM Lt
+ ȕi, UMD UM Dt
where
i
E(Ri) = the return on an asset in excess of the one-month T-bill return
h
MKT = the excess return on the market portfolio
e l
D
SMB = the difference in returns between small-capitalization stocks
of
and large-capitalization stocks (size)
HML = the difference in returns between high-book-to-market stocks
i ty
and low-book-to-market stocks (value versus growth)
r s
UMD = the difference in returns of the prior year’s winners and losers
(momentum)
v e
n i
The coefficient on MKT is not statistically different from zero, according
U
to historical data, which suggests that stock return is unconnected to the
L ,
market. Size (smaller firms outperform larger companies), book-to-market
ratio (value companies outperform glamour companies), and moment
S O
(past winners outperform past losers) are the elements that influence
stock returns.
L /
O
The four-factor model, which is widely employed in forecasting returns
/ C
for US equities, has been found to predict asset returns substantially
E
better than the CAPM.
D C There should be two observations. First, unlike the CAPM, which is
©D
supported by a theory of market equilibrium, the model does not. Second,
there is no guarantee that the model will keep operating effectively in
the future.
6.5 Arbitrage Pricing Theory

As a substitute for the CAPM, Ross (1976) created the arbitrage pricing
theory (APT) in the 1970s. The expected return of an asset (or portfolio)
in equilibrium is explained by the APT framework as a linear function
152 PAGE
ASSET PRICING
of the asset (or portfolio) risk with respect to a collection of factors Notes
that capture systematic risk. The APT, in contrast to the CAPM, does
not reveal the name or even the total number of risk factors. Rather, the
theory provides the related equation for the asset’s expected return for
any multifactor model that assumes return generation (a “return-generating
process”).
Suppose that K factors are assumed to generate returns. Then the simplest
i
explanation for a multifactor model for the return of asset i is given by
R = a + b I + b I + . . . + b I İ , ................................. (1)
l h
e
i i i1 1 i2 2 iK K i
D
where
of
Ri = the return to asset i
ai = an intercept term
Ik = the return to factor k, k = 1, 2, . . . , K
i ty
bik
r s
= the sensitivity of the return on asset i to the return to factor
k, k = 1, 2, . . ., K
v e
İi
n i
= an error term with a zero mean that represents the portion of
U
the return to asset i not explained by the factor model
L ,
Given that all of the elements bet on a value of zero, the expected return
O
of the asset I own is represented by the intercept term (ai). A multifactor
S
return-generating process (a time-series model for returns) is shown in
L /
Equation 1. The error term indicates that, in any particular time, the model
O
might not fully capture the asset’s return. But a mistake is thought to be
/ C
close to zero on average. Another popular version involves subtracting the
E
risk-free rate from both sides of Equation 1, making the return above the
D C
risk-free rate the dependent variable and the factor return above the risk-
free rate one of the explanatory variables. (The Carhart model discussed
©D
below is one illustration.)
The APT offers an expression for the anticipated return of asset i based
on Equation 1, assuming that the financial markets are in equilibrium.
The APT and the CAPM are comparable, although the APT has less firm
assumptions. Only three fundamental assumptions are made by the APT:
Asset returns are described using a factor model.
PAGE 153
Notes With a wide variety of assets available, investors can create well-
diversified portfolios that remove the risk associated with particular
assets.
Well-diversified portfolios don’t offer any prospects for arbitrage.
Arbitrage is a risk-free activity that needs no net financial investment but
generates an anticipated net profit. (Note that “arbitrage,” or the phrase
“risk arbitrage,” is also sometimes used in practice to indicate investing
i
operations in which significant risk is present). An arbitrage opportunity
is a chance to engage in an arbitrage-a chance to generate an anticipated
l h
positive net return with no risk and no net outlay of funds.
D e
of
The initial assumption doesn’t specify how many variables there are.
Investors can create portfolios with factor risk but without asset-specific
ty
risk using the second supposition. Equilibrium in the financial market is
the third presumption.
s i
r
According to empirical evidence, Assumption 2 is reasonable (Fabozzi,
e
v
2008). The asset-specific or non-systematic risk of individual stocks in a
n i
portfolio with numerous stocks contributes almost nothing to the variance
U
of portfolio returns. If these three premises are true, the following equation
L ,
holds, according to the APT:
E(R ) = R Ȝ ȕ + . . . Ȝ ȕ ..............................................(2)
O
p F 1 p,1 K p,K,
where
/ S
L
E(Rp) = the expected return to portfolio p
O
C
RF = the risk-free rate
E / Ȝj = the expected reward for bearing the risk of factor j
D C ȕp,j = the sensitivity of the portfolio to factor j
©D
K = the number of factors
The expected return on every well-diversified portfolio is linearly
proportional to the factor sensitivities of that portfolio, according to the
APT equation, Equation 2. The formula presupposes the existence of a
risk-free rate. In the absence of a risk-free asset, the expected return on a
risky portfolio with no sensitivity to any of the components is represented
by 0 in place of RF. Although the number of components is not stated, it
must be significantly less than the number of assets, a requirement that
is actually met.
154 PAGE
ASSET PRICING
The expected benefit for taking on the risk of a portfolio with a Notes
sensitivity of 1 to factor j and a sensitivity of 0 to all other factors is
represented by the factor risk premium (or factor price), j. Depending on
the multifactor model that served as the foundation for Equation 2, the
precise interpretation of “expected reward” will vary.
For instance, the risk premium for the market factor in the Carhart four-
factor model is the projected return of the market over the risk-free rate
i
(shown later in Equations 3a and 3b). The mean returns of the particular
portfolios held long (for example, the portfolio of small-cap stocks for the
l h
e
“small minus big” factor) less the mean return for a related but opposite
portfolio (for example, a portfolio of large-cap stocks, in the case of that
D
of
factor) are the factor risk premiums for the other three factors. A pure
factor portfolio for factor j (or simply the factor portfolio for factor j)
ty
is a portfolio with a sensitivity of 1 to factor j and a sensitivity of 0 to
all other factors.
s i
e r
As an illustration, let’s say that our portfolio has a sensitivity of 1 to
i v
Factor 1 and a sensitivity of 0 to all other variables. Using Equation 2,
U
and RF = 0.04, then the risk premium for Factor 1 is n
the expected return on this portfolio is E1 = RF Ȝ1 × 1. If E1 = 0.12
Ȝ1 × 1.
L ,
Ȝ1
O
í RU
S
L /
The Carhart four-factor model, usually referred to as the four-factor model
O
or just the Carhart model, is a multifactor model that is frequently used
/ C
in modern stock portfolio management. It is an expansion of the three-
E
factor model Fama and French (1992) created to incorporate a momentum
D C
factor, as it is presented in Carhart (1997). The model shows that three
categories of stocks typically outperform those indicated merely by their
©D
sensitivity to market returns:
Stocks with small capitalizations.
Stocks with a low price-to-book ratio, sometimes known as “value”
stocks.
“Momentum” stocks, or equities whose prices have been rising
recently.
PAGE 155
Notes The Carhart model postulates the existence of three systemic risk factors
in addition to the market risk factor based on that data. They are named
as follows, using the same order as above:
Small Minus Big (SMB)
High Minus Low (HML)
Winners Minus Losers (WML)
The Carhart model, which is represented by equation 3a, explains the
h i
excess return on the portfolio as a function of the portfolio’s sensitivity
e
to a market index (RMRF), a market capitalization factor (SMB), a
l
D
book-to-market factor (HML), which is essentially the reciprocal of the
of
aforementioned price-to-book ratio, and a momentum factor (WML).
Rp í RF =ap + bp1RMRF + bp2SMB + bp3HML + bp4:0/ İp, .........(3a)
where
i ty
r s
Rp and RF = the return on the portfolio and the risk-free rate of
return, respectively.
v e
n i
ap = “alpha,” or a return in excess of that expected given the
U
portfolio’s level of systematic risk (assuming the four
,
factors capture all systematic risk).
L
O
bp = the sensitivity of the portfolio to the given factor.
/ S
RMRF = the return on a value-weighted equity index in excess of
O Lthe one-month T-bill rate.

SMB = small minus big, a size (market capitalization) factor;
/ C SMB is the average return on three small-cap portfolios
C E minus the average return on three large-cap portfolios.
D HML = high minus low, the average return on two high book-to-
©D
market portfolios minus the average return on two low
book-to-market portfolios.
WML = winners minus losers, a momentum factor; WML is the
return on a portfolio of the past year’s winners minus
the return on a portfolio of the past year’s losers. (Note
that WML is an equally weighted average of the stocks
with the highest 30% 11-month returns lagged 1 month
156 PAGE
ASSET PRICING
minus the equally weighted average of the stocks with Notes

the lowest 30% 11-month returns lagged 1 month.)
İp = an error term that represents the portion of the return to
the portfolio, p, not explained by the model.
Following Equation 2, the Carhart model can be stated as giving an
equilibrium expected return as
E(Rp) = RF ȕp,1505) ȕp,260% ȕp,3+0/ ȕp,4WML .............. (3b)
because the expected value of alpha is zero.
h i
The Carhart model can be thought of as a multifactor modification of
e l
the CAPM that explicitly takes into account the factors that, from a
D
of
pure CAPM perspective, are considered anomalies and cause disparities
in expected returns among asset variables. (In this context, “anomaly”
ty
refers to an observed pattern in the capital markets that is not explained
s i
by, or contradicts, an asset pricing theory.) There are size, value, and
e r
momentum anomalies as seen by the CAPM. The Carhart model, however,
i v
views size, value, and momentum as systematic risk factors; exposure to
in mean return.
U n
them is anticipated to be made up for in the market through variations
L ,
As prevalent themes in equities portfolio creation, size, value, and
O
momentum all continue to play a significant role in active management
/ S
risk decomposition and return attribution.
IN-TEXT QUESTIONS
O L
C
3. In the APT, what is the role of arbitrage?
E /
(a) It determines the expected return of an asset
C
(b) It eliminates mispriced assets through risk-free trading
D
©D
(c) It helps in actively managing investment portfolios
(d) It identifies the systematic risk of an asset
4. Which pricing model is based on the assumption that an asset’s
expected return depends on multiple risk factors?
(a) Standard CAPM
(b) APT
(c) Active Portfolio Management
(d) Extensions of CAPM
PAGE 157
Notes 6.6 Active Portfolio Management

The framework developed by Markowitz in 1952, formerly known as
modern portfolio theory (MPT), is now widely used to explain and apply
the concepts of risk and return in portfolio management. Later, Sharpe
(1964) and other financial economists coupled a large portion of the
mathematics and vocabulary of mean-variance portfolio theory with the
idea of informational efficiency to produce equilibrium models, such as
the conventional capital asset pricing model. Separately, Treynor and
h i
l
Black (1973) used the MPT’s tools to help investors choose assets when
e
D
prices deviate from their equilibrium values. By Grinold (1989) in “The
of
Fundamental Law of Active Management” and by Black and Litterman
(1992), the application of portfolio theory to active management was
ty
further expanded.
s i
According to the active management hypothesis, an investor should build
r
a portfolio based on a presumptive competitive advantage or expertise
e
v
in return prediction. Active management hence is predicated on the idea
n i
that financial markets are not entirely efficient. Even while investors may
, U
ultimately be interested in overall risk and return, the right perspective is
risk and return compared to a benchmark portfolio when asset management
L
is left to professional investors in institutional settings (such as pension
O
S
funds). The availability of passively managed portfolios necessitates an
L /
emphasis on value-added above and beyond the option of a low-cost
O
index fund, in addition to the principal-agent problem in delegated asset
C
management.
E /
Active management seeks to enhance the value of the investment process
D C by outperforming a benchmark portfolio. Value added, also referred to

as passive investment, is a performance that is relative to investing in
©D
the benchmark portfolio. Positive value-added results from the investor
outperforming the benchmark portfolio. Negative value-added results
from the investor underperforming the benchmark portfolio. In the latter
scenario, holding the benchmark portfolio would have been the investor’s
best course of action over the measurement period, especially when fees
and expenses are taken into account.
158 PAGE
ASSET PRICING
Choice of Benchmark Notes

To be an appropriate comparison for active management, a benchmark or
passive portfolio should possess a number of characteristics.
The benchmark portfolio is frequently a readily accessible equity market
index. The most popular market indices give each assets a weight based
on their market capitalization. Since these indices typically self-rebalance
and might have multiple investors holding them at once, capitalization
i
weighting has been a key component in the development of capital
market theory. By taking into consideration the portion of a security or
l h
asset that is publicly traded and not privately held, float-adjusted market
capitalization-weighted indexes provide a slight improvement over non-
D e
of
float-adjusted indexes.
ty
When all relevant assets are included in the market, one significant effect
of employing a float-adjusted capitalization-weighted market index as the
s i
r
benchmark is that the value created through active management turns
into a zero-sum game with respect to the market. Active investors as
v e
a group cannot outperform the market since the market portfolio is the
n i
U
average performance across all investors who possess securities before
,
costs (active management is a zero-sum game). Active management is
O L
not a zero-sum game for benchmarks with a tighter definition than the
entire market because investors can choose assets outside the benchmark.
/ S
The returns to the individual securities and the weights of each asset in the
O L
benchmark portfolio, RB, are used to calculate the return on the portfolio:
/ C
N
R B = ∑ W B,i R i ....................................................................................(1)
i =1
C E
where N is the number of stocks, wB,i is the security i’s benchmark weight,
D
©D
and Ri is its return. The weights of the stocks, i, held in the portfolio,
wP,i, and the returns on the individual securities both affect the return on
an actively managed portfolio, RP:
N
R P = ∑ W P,i R i ..................................................................................... (2)
i =1
The benchmark could contain securities that, by definition, have a weight

of zero because they are not a part of the actively managed portfolio or
they could just not be factored into Equation 2’s computation. Similarly, a
shareholder might add stocks to their active portfolio that are not included
PAGE 159
Notes in the benchmark, in which case Equation 1 would provide a benchmark

weight of 0 to such securities. Please take note that, for the sake of
simplicity, the managed portfolio return and the benchmark return are
added together using the same notation, N, even if the managed portfolio
may contain fewer or more securities than the benchmark.
Measuring Value Added
The simple difference between the return on an actively managed portfolio
i
and the return on the benchmark portfolio is often used to measure the
value added or “active return” of that portfolio.
l h
RA = RP í RB,
D e
of
Hence, can be either positive or negative. The managed portfolio’s alpha,
which we shall refer to as the risk-adjusted computation of value-added,
ty
includes an estimation of the risk of the managed portfolio in relation
s i
to the benchmark, which is frequently expressed by the portfolio’s beta,
r
ĮP = RP íȕPRB. Sadly, the term “alpha” is frequently employed in practice
e
v
to refer to “active return,” which implicitly assumes that the managed
n i
portfolio’s beta in relation to the benchmark equals 1.
, U
The crucial idea that value added is ultimately determined by the variations
in managed portfolio weights and benchmark weights can be illustrated
O L
E\ FRPELQLQJ (TXDWLRQV DQG ǻwi = wP,i í wB,i7KH V\PEROǻ *UHHN
S
letter delta) is used to denote the deviation from the benchmark weights,
L /
and these values are known as the active weights of the managed portfolio.
O
The conceptually significant result that value added is the product of
/ C
active weights and asset returns is obtained by combining Equations 1
CE
and 2 and using this definition for active weights:
N
R A = ∑ Δ Wi Ri
D D i =1
© Given that the active weights’ sum is zero, the value-added may also be
expressed as the sum of the active security returns and active weights:
N
R A = ∑ Δ Wi R Ai ................................................................................ (3)
i =1
RAi = Ri – RB, etc. According to Equation 3, when securities with returns
higher than the benchmark are overweighted and securities with returns lower
than the benchmark are underweighted, positive value added is produced.
160 PAGE
ASSET PRICING
Decomposition of Value Added Notes

Performance attribution systems frequently aim to break down the value
added into several sources, in contrast to the prior straightforward example.
The value added as a result of asset allocation and value added as a result
of security selection are typically divided into two categories. Consider
a stock and bond composite portfolio with asset allocation weights that
are different from a composite benchmark and active security selection
within each asset class. The discrepancy between the actual portfolio
return and the benchmark return is the total value added:
h i
M M
R A ∑ W P, j R P, j − ∑ W B, j R B, j
e l
j =1 j =1
D
of
Portfolio weights and returns on actively managed portfolios, denoted by
the “P” subscript, are included in the initial summation. The “B” subscript
ty
indicates that the second summing includes benchmark returns as well
as weights. The notation subscript i = 1 to N is left for use elsewhere
s i
to count the securities inside each asset class whereas the subscript j =
e r
1 to M counts the number of asset classes.
i v
U n
The overall value added can be rewritten as the weighted sum of the
value contributed through security selection, RA,j =RP,j – RB,j, within each
L ,
asset class, and the active asset allocation decisions:
O
M M
R A = ∑ Δ W j R B, j + ∑ W P, j R A, j ......................................................... (4)
j =1 j =1
/ S
O L
Despite the fact that this formulation arbitrarily gives security selection an
interactive effect. Equation 4’s performance attribution method could be simpler
/ C
to understand if there were only two asset classes, stocks and bonds (or if M
E
= 2). Equation 4 becomes Equation 4 with stocks and bonds as the subscripts:
C
D
RA ¨wstocks RB,stocks ¨wbonds RB,bonds) + (wP,stocks RA,stocks + wP,bonds RA,bonds)
©D
The value added as a result of the asset allocation choice is the first
(parenthetical) term. The value added by security selection inside the stock
and bond portfolios is the second term. The first term’s active weights
refer to deviations from the policy portfolio.
Question 4: The following information is available for a portfolio
comprising equities and bonds:
ICICI (equity) mutual fund return: 36.4%
Benchmark return: 33.3%
PAGE 161
Notes Indiabulls (bond) return: –1.8%

Benchmark return: –2.1%
Strategic asset allocation: 60% in equities and 40% in bonds.
Investor’s asset allocation in the actively managed funds: 68% in
ICICI and 32% in Indiabulls.
Given the above information, compute the total value added due to active
asset allocation and security selection.
h i
l
Solution:
Portfolio return = 0.68×36.4 + (–1.8)×0.32 = 24.18%
D e
of
Benchmark return = 0.60×33.3 + (–2.1)×0.4 = 19.14%
Value added = 24.18% – 19.14% = 5.04%
ty
Combined value from asset allocation = 0.08(33.3) + (–0.08X–2.1)= 2.83%
s i
r
Combined value added from security selection × 0.68 (3.1) + 0.32 (0.3)
= 2.20%
v e
IN-TEXT QUESTIONS
n i
, U
5. Which approach involves active management of a portfolio to
achieve superior returns?
O L
(a) Passive Portfolio Management
/ S
(b) Efficient Market Hypothesis
L
(c) Active Portfolio Management
CO
E/
(d) Modern Portfolio Theory
6. Active Portfolio Management involves:
DC
(a) Constructing a portfolio that closely mimics a specific
©D
benchmark
(b) Buying and holding a diversified portfolio of assets
(c) Attempting to outperform a benchmark through active
trading and security selection
(d) Investing in assets with low systematic risk
162 PAGE
ASSET PRICING
6.7 Summary Notes
The subject of asset pricing is covered in depth in Chapter X of Unit V,

with an emphasis on the Standard Capital Asset Pricing Model (CAPM),
CAPM extensions, Arbitrage Pricing Theory (APT), and Active Portfolio
Management. Grasp the connection between risk and return in financial
markets requires a grasp of these ideas.
Asset pricing is built on the Standard Capital Asset Pricing Model
(CAPM). According to the CAPM, the expected return on an asset can
h i
be determined by multiplying the risk-free rate by a risk premium. The
e l
D
asset’s beta, which gauges its volatility in relation to the market as a
of
whole, determines this risk premium. To put it another way, the CAPM
makes the assumption that investors want payment for assuming systematic
ty
risk, which is represented by the asset’s beta.
The CAPM, however, has some drawbacks. As a result, a number of
s i
e r
expansions have been suggested to improve its efficacy. The Fama-French
i v
model is one such extension, adding the two extra elements of size
U n
and value to the CAPM. While the value factor takes into account the
outperformance of equities with lower price-to-book ratios, the size factor
L ,
takes into account the propensity of smaller companies to outperform
O
larger ones. The Fama-French model aims to more accurately reflect the
/ S
intricacies of asset pricing by integrating these variables.
O L
The Carhart four-factor model is another addition to the CAPM. The
Carhart model includes a momentum element in addition to size and
/ C
value, which accounts for the propensity for stocks that have done well
C E
in the past to do so in the future. The model attempts to represent the
influence of market movements on asset values by incorporating this
D
©D
momentum element.
An alternative to the CAPM is provided by the arbitrage pricing theory
(APT). APT is a more thorough theory that contends that various factors,
as opposed to mere volatility as in the CAPM, affect an asset’s expected
return. The expected return on an asset can be computed using the APT
by adding the risk-free rate and the risk premium for each factor that
affects the asset’s price. These variables can take many different forms
and include economic ones like interest rates and inflation as well as
non-financial ones like political developments or technological advances.
PAGE 163
Notes The APT is aware that there are many elements besides market volatility
that affect asset pricing.
The process of choosing assets for a portfolio with the intention of beating
a benchmark is known as active portfolio management. Active portfolio
managers use a variety of techniques and variables to spot mispriced
assets and profit from market imperfections. These tactics may involve
using the CAPM, APT, or even the manager’s personal discretion. To
i
maximise profits and limit risks, active portfolio management constantly
monitors and modifies the composition of the portfolio.
l h
D e
Finally, asset pricing is an important component of financial markets.
A fundamental framework for comprehending the relationship between
of
risk and return is provided by the Standard Capital Asset Pricing Model
(CAPM). The CAPM has been expanded, though, with models like the
i ty
Fama-French and Carhart models that include new variables to account
r s
for market complexities. APT provides a broader viewpoint on asset
e
pricing by taking into account a larger range of variables in addition to
v
n i
volatility. These ideas and tactics are used in active portfolio management
to actively choose assets with the goal of outperforming benchmarks.
U
Investors can learn about asset value by studying these ideas, which will
,
L
help them make wise choices as they pursue their financial goals.
S O
/
6.8 Illustrations
O L
Illustration 1: At the time of valuation, the estimated betas for JPMorgan
/ C
Chase & Co. and Boeing Company were 1.4 and 0.90, respectively. The
C Erisk-free rate of was 4.45%, and the equity risk premium was 8.10%.
Based on these data, calculate the required rates of return for these two
D stocks using the CAPM model.
©D
Solution:
For JPMorgan Chase, the required return is
r = RF ȕ >E(RM) – RF]= 4.45% + 1.40(8.10%) = 4.45% + 11.34% =
15.79%
For Boeing the required return is
r = RFȕ>E(RM) – RF] = 4.45% + 0.9(8.10%) = 4.45% + 7.29% = 11.74%
164 PAGE
ASSET PRICING
Illustration 2: An analyst’s data source shows that X Mining has an Notes

estimated beta of –0.3. The risk-free rate of return is 2.8%, and the equity
risk premium is estimated to be 4.2%. Using the CAPM, calculate the
required rate of return for investors in X Mining.
Solution:
The required return is given by
r = 0.028 + (–0.3)(0.042) = 0.028 – 0.0126 = 0.0154 = 1.54%
Illustration 3: The benchmark weights and returns for each of the five
h i
stocks in the Capital Index are given in the following table. The BMS
e l
D
Fund uses the Capital Index as its benchmark, and the fund’s portfolio
of
weights are also shown in the table.
Stock Portfolio Weight (%) Benchmark Weight (%) 2022 Return (%)
1 25 22 15
i ty
2 25 22 16
r s
e
3 20 20 13
4 15 18
i v
9
5 15 18
U n 10
,
What is the value added (active return) for the BMS Fund?
Solution:
O L
S
The portfolio active return is equal to the portfolio return minus the
benchmark return:
L /
RA = RP – RB
C O
/
The portfolio return (R p) = 0.25(15%) + 0.25(16%) + 0.20(13%) +
E
C
0.15(9%) + 0.15(10%) = 13.2%
D
The benchmark return (RB) = 0.22(15%) + 0.22(16%) + 0.20(13%) +
©D
0.18(9%) + 0.18(10%) = 12.84%
Thus, the active return is
RA = RP – RB = 13.2% – 12.84% = 0.36%
Illustration 4: Consider the following asset class returns for calendar
year 2023.
PAGE 165
Notes Asset Class Portfolio Benchmark Portfolio Benchmark

Weight (%) Weight (%) Return (%) Return (%)
Domestic equities 50 45 12 9
International 25 30 12 8
equities
Bonds 25 25 6 7
What is the value added (or active return) for the managed portfolio?
Solution:
h i
l
The active portfolio active return is equal to the portfolio return minus
e
D
the benchmark return:
of
RA = RP – RB
The portfolio return (Rp) = 0.50(12%) + 0.25(12%) + 0.25(6%) = 10.5%
i ty
The benchmark return (RB) = 0.45(9%) + 0.30(8%) + 0.25(7%) = 8.2%
Thus, the active return is
r s
RA = RP – RB = 10.5% – 8.2% = 2.3%
v e
n i
U
,
1. (a) Risk-averse
O L
/ S
2. (a) The risk-free rate plus the beta of the asset multiplied by the
L
market risk premium
O
3. (b) It eliminates mispriced assets through risk-free trading
C
/
4. (b) APT
CE
5. (c) Active Portfolio Management
D D 6. (c) Attempting to outperform a benchmark through active trading
©
and security selection

1. What is the Standard Capital Asset Pricing Model (CAPM) and
how is the expected return of an asset calculated using it?
2. Describe the CAPM’s assumptions and their limitations in practical
applications.
166 PAGE
ASSET PRICING
3. What are the primary CAPM additions or adjustments done to Notes

enhance its precision and address its flaws?
4. Explain the Arbitrage Pricing Theory (APT) idea and how it differs
from the CAPM in terms of how asset pricing is explained.
5. Compare and contrast the key assumptions and implications of the
CAPM and APT.
6. Discuss the main factors or variables commonly used in the APT
framework to explain asset returns.
h i
7. Explain the concept of active portfolio management and the strategies
e l
D
employed by portfolio managers to outperform the market.
of
8. Analyze the empirical evidence on the effectiveness of active
portfolio management strategies compared to passive management
ty
approaches.
s i
r
9. Describe the different approaches or techniques used to evaluate the
performance of actively managed portfolios.
v e
i
10. Discuss the advantages and disadvantages of using active portfolio
n
U
management strategies for individual investors.
6.11 References
L ,
S O

L /
Buckle, David. 2004. “How to Calculate Breadth: An Evolution of
the Fundamental Law of Active Portfolio Management.” Journal of
O
Asset Management 4 (6): 393–405.
C

E /
Carhart, Mark M. 1997. “On Persistence in Mutual Fund Performance.”
C
Journal of Finance 52 (1): 57–82.

D
Clarke, Roger, Harindra de Silva, and Steven Thorley. 2002. “Portfolio
©D
Constraints and the Fundamental Law of Active Management.”
Financial Analysts Journal 58 (5): 48–66.
Connor, Gregory. 1995. “The Three Types of Factor Models: A
Comparison of Their Explanatory Power.” Financial Analysts Journal
51 (3): 42–46.
Dopfel, Frederick E. 2004. “Fixed-Income Style Analysis and Optimal
Manager Structure.” Journal of Fixed Income 14 (2): 32–43.
PAGE 167
Notes Fama, Eugene F., and Kenneth R. French. 1992. “The Cross-Section
of Expected Stock Returns.” Journal of Finance 47 (2): 427–65.
Podkaminer, Eugene L. 2017. “Smart Beta Is the Gateway Drug to
Risk Factor Investing.” Journal of Portfolio Management 43 (5):
130–34.
Ross, S. A. 1976. “The Arbitrage Theory of Capital Asset Pricing.”
Journal of Economic Theory 13 (3): 341–60.
h
Sharpe, William F. 1964. “Capital Asset Prices: A Theory of Market
i
l

e
Equilibrium under Conditions of Risk.” Journal of Finance 19 (3):
D
425–42.
of
Treynor, J., and Fischer Black. 1973. “How to Use Security Analysis
to Improve Portfolio Selection.” Journal of Business 46:66–86.
i ty
r s
v e
i
Black, Fischer, and Robert Litterman. 1992. “Global Portfolio
U n
Optimization.” Financial Analysts Journal 48 (5): 28–43.
Bodie, Zvi, Alex Kane, and Alan J. Marcus. 2017. Investments. 11th
,

L
ed. New York: McGraw-Hill Education.

S O
Burmeister, Edwin, Richard Roll, and Stephen A. Ross. 1994.
L /
“A Practitioner ’s Guide to Arbitrage Pricing Theory.” In
A Practitioner’s Guide to Factor Models. Charlottesville, VA:
C O
Research Foundation of the Institute of Chartered Financial Analysts.
E

/ Clarke, Roger, Harindra de Silva, and Steven Thorley. 2005. “Performance
C
Attribution and the Fundamental Law.” Financial Analysts Journal
D 61 (5): 70–83.
©D
Clarke, Roger, Harindra de Silva, and Steven Thorley. 2006. “The
Fundamental Law of Active Portfolio Management.” Journal of
Investment Management 4 (3): 54–72.
Cremers, K.J. Martijn, and Antti Petajisto. 2009. “How Active Is Your
Fund Manager?” Review of Financial Studies 22 (9): 3329–65.
Elton, Edward, and Martin Gruber. 1973. “Estimating the Dependence
Structure of Share Prices.” Journal of Finance 28 (5): 1203–32.
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ASSET PRICING
Fabozzi, Frank J. 2008. Handbook of Finance, Financial Markets Notes

and Instruments. Wiley.
Fischer, Bernd, and Russell Wermers. 2013. Performance Evaluation
and Attribution of Security Portfolios. Oxford, UK: Elsevier Inc.
Grinold, Richard, and Ronald N. Kahn. 1994. “Multi-Factor Models
for Portfolio Risk.” In A Practitioner’s Guide to Factor Models.
Charlottesville, VA: Research Foundation of the Institute of Chartered
i
Financial Analysts.
Grinold, Richard C. 1989. “The Fundamental Law of Active Management.”
l h
e

D
Journal of Portfolio Management 15 (3): 30–37.
of
Grinold, Richard C. 1994. “Alpha Is Volatility Times IC Times Score,
or Real Alphas Don’t Get Eaten.” Journal of Portfolio Management
ty
20 (4): 9–16.

s i
Grinold, Richard C., and Ronald N. Kahn. 1999. Active Portfolio
e r
Management: A Quantitative Approach for Providing Superior
i v
Returns and Controlling Risk. 2nd ed. New York: McGraw-Hill.

7 (1): 77–91.
U n
Markowitz, Harry M. 1952. “Portfolio Selection.” Journal of Finance

L ,
Qian, Edward, and Ronald Hua. 2004. “Active Risk and Information
O
Ratio.” Journal of Investment Management.
S
L /
C O
E /
D C
©D
PAGE 169
L E S S O N
7
Evaluation of Investment
Performances
Rinki Dahiya
Assistant Professor
i
Department of Economics
l h
Sri Guru Nanak Dev Khalsa College
e
University of Delhi
D
STRUCTURE of
i ty
s
7.2 Introduction
e r
7.3 Evaluation of Investment Performances
i v
7.4 Measures of Portfolio Performance
U n
7.5 Return Attribution
L ,
O
7.7 Summary
/ S
L
O
/ C
7.10 References
C E
D

©D
Understand the necessity of performance evaluation.
Recognise the problems in assessing portfolio performance.
Explains how performance evaluation fits into the investment management process.
Recognise the necessity for portfolio revision.
170 PAGE
EVALUATION OF INVESTMENT PERFORMANCES
Contrast active and passive portfolio revision techniques. Notes

Recognise ideas like style analysis and performance attribution.
Describe the objectives of return attribution and its function in the
investment decision-making process.
Describe the benefits of performance evaluation information to various
stakeholders.
Describe the main activities that make up the performance evaluation
i

h
process and how they connect to one another.
e l
7.2 Introduction
D
Information about the performance of an investor’s investment portfolio
of
ty
that is accurate and up-to-date is essential for investment managers and
s i
investors. Such information is provided by performance evaluation. Without
r
it, in a highly competitive investment management sector, investors and
e
v
investment managers would find it increasingly challenging to meet
stakeholders’ present and future needs.
n i
, U
The measurement, analysis, interpretation, appraisal, and presentation
of investment results are all parts of what is referred to as performance
O L
evaluation in the investment management sector. Performance evaluation
S
in particular offers details on the return and risk of investment portfolios
L /
over predetermined time frames. Due to its role in keeping an eye on
O
portfolios, performance evaluation is a crucial component of investment
management.
/ C
C E
Investment is the initial giving up of something that have value in
exchange for the hope of receiving more in return. The return is the
D
difference between what we invested and what we received; we make
©D
investments in order to generate this return. For financial assets, return
comprises both the income received between the time of purchase and
sale as well as the gain we will ultimately obtain when we either sell
them to another party or wait for them to mature. Returns are a form of
remuneration for forfeiting the use of capital in the interim.
Therefore, the “bottom line” of the investment process, which include
assessing and comprehending the performance of a portfolio remains a
crucial concern. Whether an individual investor manages his or her own
PAGE 171
Notes money directly or indirectly through investing firms, this is crucial to

understand.
Direct investing has large opportunity costs and can be time-consuming.
On the other hand, it is important to understand how effective any
professional portfolio managers (such as mutual fund managers) are if they
are employed. Investors should favour manager A if manager A routinely
outperforms manager B. Alternately, if neither A nor B outperforms an
i
index fund, investors may favour neither. The apparent conclusion is
l
that performance must be assessed before wise decisions about current
h
e
portfolios can be made.
D
Over the years, techniques for evaluating investment performance have
of
advanced, and portfolio clients’ demands have grown increasingly stringent.
The evaluation process and how it is perceived have changed as a result
i ty
of current portfolio theory’s widespread acceptance.
r s
What goes into the appraisal of investment performance is covered in
e
this chapter. In addition to discussing performance benchmarks, and
v
i
performance presentation standards, it also includes well-known measures
n
U
of portfolio performance such the Sharpe measure. An attempt has been
,
made to address some of the issues that performance evaluation addresses
O L
like – What were the effects of the investment choices? Are portfolios
being managed in accordance with investors’ expectations and their
/ S
mandates? And what steps have been taken to help clients reach their
L
investment objectives?
O
/ C
7.3 Evaluation of Investment Performances
C E
D
Performance evaluation enables investment managers (and the portfolio
©D
managers they employ) to take corrective actions to enhance investment
decision making and management processes by providing reliable data and
analysis on investment decisions and their outcomes. Information from
performance evaluations aids in comprehending and managing investment
risk, which should result in greater risk management.
Beginning with return calculation, performance evaluation encompasses a
wide range of discrete but linked actions. These activities include details
on both the final investment outcomes and the investment choices that
led to those outcomes. Performance evaluation, describes performance
172 PAGE
and examines why progress towards investor objectives took the course Notes
that it did. Performance assessment is a feedback method that aids in
coordinating portfolio attributes with investor goals.
Because it offers feedback on the consequences of investment activities
and decisions on portfolio performance, performance evaluation is a crucial
step in the investment management decision-making process. Both internal
and external stakeholders, including asset owners, investment consultants,
i
and regulators, can benefit from this information. Internal stakeholders
include portfolio managers, senior management, risk managers, compliance
l h
e
experts, and marketing and sales employees.
Why Evaluation of Investment Performance is Important?
D
Performance evaluation enables investment managers (and the portfolio
of
ty
managers they employ) to take corrective actions to enhance investment
i
decision making and management processes by providing reliable data and
s
r
analysis on investment decisions and their outcomes. Information from
e
performance evaluations aids in comprehending and managing investment
v
i
risk, which should result in more effective risk management.
n
U
Performance evaluation communicates portfolio managers’ outcomes
L ,
to asset owners and potential clients. In general, by giving pertinent
information about performance and its determinants, it enables asset
S O
owners and potential clients to make better decisions (including selection,
/
continuation, and dismissal) about investment managers.
L
O
For asset owners and potential clients, correct performance presentations
/ C
are particularly crucial for facilitating proper analysis. Investment managers,
E
asset owners, and other stakeholders may be significantly impacted by
D C
performance evaluation in its feedback role.
For investing professional’s performance evaluation is effective monitoring
©D
of risk and return in relation to the investor’s objectives and the designated
benchmark; prompt attention to potential performance issues and unintended
business or investment risks; an efficient internal management information
system; efficient internal monitoring and oversight management/mechanisms.
For both asset owners and investment manager’s performance evaluation
aids in a thorough grasp of the many actions and choices made during
the investment management process and how they affect performance.
By using more objective and less subjective investment performance data
PAGE 173
Notes during the performance assessment process, non-focused discussions can

be reduced. Dialogue between stakeholders can also result in innovation,
changes to practises, a strengthened brand and reputation, and new,
appealing investment products for investors.
For asset owners the performance evaluation takes changes in investment
strategy, style, or restrictions into account and informs them of these. The
performance review accurately and objectively depicts the investments
i
made, outcomes obtained, risks taken, and costs and taxes paid. Risk
l
and return are both taken into account when evaluating performance. The
h
e
performance evaluation offers comparisons, such as a suitable benchmark,
D
to allow evaluation of the relative performance of the investment portfolio.
7.4 Measures of Portfolio Performance of

i ty
s
A portfolio is a collection of financial assets such mutual funds, exchange-
e r
traded funds, closed-fund counterparts, stocks, FDs, bonds, and cash
i v
equivalents. A chance for risk diversification is provided by the portfolio.
n
Risk diversification does not imply that risk will be eliminated. Diversifiable
, U
or unsystematic risk and undiversifiable or systematic risk are the two
categories of risk that come with any asset. Even the ideal portfolio can
O L
only minimise or eliminate the diversifiable risk; it cannot completely
S
remove market risk. Risk is inversely correlated with return variability.
L /
The professional management of securities and other assets is referred to
O
as portfolio management. Likewise known as “wealth management” and
C
/
“asset management.” It is the art of choosing the best investment tools
C Ein the proper amounts to provide the best returns while maintaining a
healthy balance of risk from the initial investment. The best portfolio
D management techniques operate under the premise of highest return with
©D
a minimum amount of risk over a certain period of time. Based on an
investor’s income, investment budget, and risk tolerance while keeping
in mind the anticipated rate of return, a portfolio is created.
In the current environment, people hire skilled and experienced portfolio
managers who, based on the client’s risk tolerance, combine multiple
investment products to create a tailored portfolio with long-term returns
that are guaranteed. Every person needs to set aside a portion of their
174 PAGE
money and invest it in something that will help them in the future. A Notes
portfolio is a collection of different financial goods into which a person
spends their money.
Reasons for evaluating Portfolio performance
The essence of investing is measuring the performance of a portfolio.
Anyone who manages their own portfolios or entrusts their money to
others to handle wants to know how they are doing as investments.
i
Additionally, people should be aware of what to look for when investment
results are presented to them if they use others to handle their money or
l h
read investing newsletters.
The examination of a portfolio’s performance is largely concerned with
D e
of
determining how well it has fared in contrast to some benchmark. If the
portfolio has exceeded, underperformed, or performed on par with the
benchmark, the evaluation can show how much.
i ty
r s
The performance of a portfolio should be evaluated for a number of
e
reasons. The investor, whose money has been placed in the portfolio,
v
n i
must first be aware of the portfolio’s comparative performance. The
performance review must produce and offer data that will enable the
, U
investor to determine whether rebalancing of his portfolio is necessary.
L
Second, if the manager’s compensation is linked to the success of the
O
portfolio, the management of the portfolio needs this information to assess
S
/
the manager’s performance and decide that compensation.
O L
For both investors and fund managers, evaluating an investment portfolio
is a crucial duty. Particularly when that portfolio manager is appointed to
/ C
run a mutual fund, pension fund or any other collective investment plan
E
has a greater professional interest in reviewing a portfolio performance.
C
D
Companies that manage funds and portfolios on behalf of their principals
©D
are required by regulatory organisations to submit to the capital market
authorities the appraisal of their performance on a frequent basis, even
if previous performance does not guarantee future success.
In terms of agency theory, portfolio management evaluation is equally
crucial. Conflicts between the principals (i.e., customers, investors) and the
agent (portfolio manager) may arise during the examination of financial
portfolios. There are numerous ways in which this might happen. A moral
hazard issue would arise, for instance, if a portfolio manager suddenly
decided to take a high-risk position against the wishes of her or his client.
PAGE 175
Notes As another illustration, Financial illiteracy among investors is crucial

because, the manager could present his or her performance in a way that
misleads investors into picking him or her to handle their funds. Finally,
a portfolio manager may perform worse than the benchmark and perform
poorly in attribution analysis (i.e., allocation and selection effects), which
constitutes an adverse selection issue.
Techniques for evaluating Portfolio performance
i
The examination of portfolio performance involves determining how a
l h
managed portfolio has performed in contrast to some benchmark. Approaches
D e
for performance evaluation typically fall into one of two categories:
traditional approaches or methods that account for risk. The two standard
of
strategies that are most frequently employed are benchmark comparison
and style comparison. In order to account for variations in risk levels
i ty
between the managed portfolio and the benchmark portfolio, risk-adjusted
r s
approaches modify returns. The Sharpe ratio, Treynor ratio, Jensen’s alpha
e
and Modigliani and Modigliani (M2) are the principal techniques. The
v
i
risk-adjusted approaches are favoured above the traditional approaches.
n
U
The two main categories of performance evaluation techniques are:
Conventional Methods
L ,
O
1. Benchmark Comparison
/ S
Comparing the performance of an investment portfolio to a larger market
O L
index is the most basic traditional approach. The Nifty 50 index, which
represents the weighted average of 50 Indian equities listed on National
/ C
stock exchange, is the most popular market index in the India. The
C Eportfolio is considered to have outperformed the benchmark index if its

return, assessed over the same time periods, is higher than that of the
D benchmark index.
©D Even while this kind of comparison with a passive index is quite popular in
the investment industry, it poses a unique issue. The investment portfolio’s
level of risk could differ from the benchmark index portfolio’s level.
Long-term rewards should be higher when there is a higher risk involved.
In other words, if the investment portfolio has outperformed the benchmark
portfolio, it may be because it is riskier than the benchmark portfolio.
176 PAGE
Therefore, comparing an investment portfolio’s return to that of a benchmark Notes

portfolio may not yield accurate results.
2. Style Comparison
The return of a portfolio is compared to another portfolio with a similar
investing style as part of the “style-comparison” method, a second
traditional performance evaluation technique. Despite the fact that there
are numerous investment types, one widely utilised method divides them
i
into value and growth categories.
The “value style” portfolios make investments in businesses that are
l h
viewed as being undervalued using metrics like price-to-earnings and
D e
of
price-to-book value multiples. The “growth style’’ portfolios invest in
businesses whose revenue and earnings are anticipated to expand more
ty
quickly than those of the typical corporation.
s i
A value-oriented benchmark portfolio’s return would be compared to that of
r
a value-oriented benchmark portfolio in order to assess the performance of
e
v
the latter. Similar comparisons are made between a growth style portfolio
n i
and a growth style benchmark index. This strategy also has the drawback
U
of perhaps having varying risks between the two examined portfolios,
L ,
even though their styles may appear to be comparable. Additionally, the
benchmarks used could not be actually comparable in terms of style because
S O
two funds with identical styles can differ in a number of significant ways.
Risk-adjusted Methods
L /
O
In order to account for the variations in risk levels between the managed
C
/
portfolio and the benchmark portfolio, the risk-adjusted methods modify
C E
returns. Although there are other similar techniques, the Sharpe ratio (S),
Treynor ratio (T), Jensen’s alpha (Į), Modigliani and Modigliani (M2)
D
stand out as the most prominent ones. These measurements are detailed
©D
here, along with the applications for them.
Treynor Ratio
Investors were first given a composite measure of portfolio performance
that took risk into account by Jack L. Treynor. Finding a performance
metric that could be used by all investors, regardless of their individual
risk inclinations, was Treynor’s goal.
According to Treynor, there are actually two parts to risk: the risk
brought on by stock market fluctuations and the risk brought on by the
PAGE 177
Notes fluctuations of specific assets. The risk premium per unit of systematic
risk is calculated using the Treynor ratio. The Sharpe measure defines
the risk premium. The way this method differs is that the risk parameter
is the portfolio’s systematic risk.
The systemic risk is the portion of an asset’s overall risk that cannot
be completely reduced by diversification. The “beta” parameter, which
indicates the slope of the regression between the returns from the managed
i
portfolio and the returns from the market portfolio, is used to measure
l h
it. The term “security market” was first used by Treynor to describe the
e
relationship between portfolio returns and market rates of return; the
D
slope of the line represents how volatile the portfolio is in comparison
of
to the market (represented by beta).
The following equation provides the Treynor ratio:
i ty
Treynor ratio = return of portfolio – risk free rate/beta of portfolio
r s
The portfolio risk is represented by the denominator, and the numerator
v e
represents the risk premium. The calculated figure is the portfolio’s return
n i
on each unit of risk. The volatility of a stock portfolio in relation to
U
the market is measured by the beta coefficient. The risk-return tradeoff
,
improves with increasing line slope.
L
O
Illustration: The typical annual return for a portfolio manager is 10%.
S
And the other details are as follows:
L /
Risk-free rate- 4%
O
Portfolio’s beta- 0.8
C
E /
Return volatility- 20%.
D C The market index’s standard deviation of returns is 25%, while its average
annual return is 12%. Determine the portfolio’s Treynor measure.
©D
Solution: The formula to calculate Treynor measure is:
Treynor ratio = return of portfolio – risk free rate / beta of portfolio
= 10% – 4% / 0.8
= 7.5
Sharpe Ratio
The Treynor measure and the Sharpe ratio are nearly identical, with the
exception that the risk metric used in the latter is the portfolio’s standard
178 PAGE
deviation rather than only beta’s representation of systematic risk. Total Notes
risk is used to compare portfolios to the capital market line in this Bill
Sharpe-created measure, which closely follows his work on the Capital
Asset Pricing Model (CAPM).
The risk premium of an investment portfolio is calculated using the Sharpe
ratio as one unit of total portfolio risk. The return on the portfolio less
the risk-free rate of interest as determined by the yield of a Treasury
i
asset is the risk premium, sometimes referred to as excess return.
Sharpe Ratio = return of portfolio – risk free rate/standard deviation of
l h
return of the portfolio
D e
of
The standard deviation of the portfolio’s returns represents overall risk.
The numerator represents the benefit for investing in a hazardous portfolio
ty
of assets over the risk-free rate of interest, while the denominator represents
s i
the portfolio’s return variability. The Sharpe measure is also known as
the “reward to variability” ratio in this context.
e r
i v
Illustration: Three portfolio options are available to a client, each with
the following features:
U n
,
Expected Return Volatility Beta
L
Portfolio X 17 14 11
Portfolio Y 20
S O 16 12
Portfolio Z
L /
14 11 6
O
The expected return on the efficient market portfolio is 22%, the standard
C
deviation is 14%, and the risk-free rate of interest is 7%. The client
E /
should select which portfolio based Sharpe ratio?
D C
Solution: The formula to calculate Sharpe ratio is:
Sharpe Ratio = return of portfolio – risk free rate/standard deviation of
©D
return of the portfolio
Therefore, Portfolio X’s Sharpe ratio = 17% – 7% / 14% = 0.714
Portfolio Y’s Sharpe ratio = 20% – 7% / 16% = 0.812
Portfolio Z’s Sharpe ratio = 14% – 7% / 11% = 0.636
Given that portfolio Y has the highest Sharpe ratio i.e. 0.812, the client
should select it. So, the decision rule is greater the slope or higher the
Sharpe ratio the better the asset.
PAGE 179
Notes The Sharpe ratio, in contrast to the Treynor measure, assesses the portfolio
manager based on both rate of return and diversification (it takes into
account total portfolio risk as indicated by the standard deviation in its
denominator). Because it more correctly accounts for the risks of the
portfolio, the Sharpe ratio is therefore more suited for well-diversified
portfolios.
Depending on the projections for the investments, the investor can use either
i
Sharpe or Treynor method. Like, if the P is diversified, non-systematic
l h
risk is little, and Treynor’s, which measures excess return to beta, is the
e
right metric. Otherwise, use the Sharpe measure, which measures reward
to risk, if P is not diversified.
D
of
Jensen’s Alpha
ty
The Jensen measure, which bears the name of its inventor, Michael C.
i
Jensen, determines the excess return that a portfolio achieves over its
s
r
projected return. The Capital Asset Pricing Model (CAPM) of Sharpe
e
(1964), Lintner (1965), and Mossin (1966) is the foundation for Jensen’s
v
i
alpha. The alpha measures the deviation between the portfolio’s average
n
U
return and the expected return predicted by the CAPM. In terms of the
,
risk-free rate, systematic risk, and market risk premium, the CAPM
O L
specifies the expected return. The alpha can be higher, lower, or equal
to zero. An alpha of larger than zero indicates that the portfolio’s rate
/ S
of return was higher than its expected return. The alpha is provided by
Jensen.
O L
C
Jensen’s alpha = return of portfolio – {risk free rate + beta of portfolio
E /
(return of the market portfolio – risk free rate)}
D C The Jensen ratio calculates the percentage of the portfolio’s rate of return
that may be attributed to the manager’s capacity for above-average returns
©D
after taking account of market risk. The better the risk-adjusted returns,
the higher the ratio. A portfolio with an excess return that is constantly
positive will have a positive alpha, whereas a portfolio with an excess
return that is consistently negative will have a negative alpha.
Illustration: Two portfolios- X and Y have the following characteristics:
Return Beta
Portfolio X 10% 0.9
Portfolio Y 9% 1.5
180 PAGE
Determine Jensen’s Alpha for both portfolios with a market return of Notes
12% and a risk-free rate of 5%. And also comment on which portfolio
has fared better.
Solution: The formula to calculate Jensen’s Alpha ratio is:
Jensen’s alpha = return of portfolio – {risk free rate + beta of portfolio
(return of the market portfolio – risk free rate)}
Jensen’s alpha for Portfolio X = 0.1 – {0.05 + 0.9 (0.12 – 0.05)}
= 0.1 – {0.05 + 0.9 (0.07)}
h i
= 0.1 – 0.113
e l
= - 0.013
D
Jensen’s alpha for Portfolio Y = 0.09 – {0.05 + 1.5 (0.12 – 0.05)}
of
ty
= 0.09 – {0.05 + 1.5 (0.07)}
= 0.09 – 0.155
s i
= –0.065
e r
i v
For portfolios X and Y, Jensen’s Alpha is –1.3% and –6.5%, respectively.
U n
A stronger portfolio performance is indicated by higher Jensen’s Alpha. In
,
this case, Jensen’s alpha for Portfolio X (–1.3%) is higher than Jensen’s
alpha for Portfolio Y (–6.5%).
O L
S
Modigliani and Modigliani or M squared (M2)
L /
M squared (M2) is another ratio, like the Treynor ratio, that assesses the
O
portfolio’s risk-adjusted return in comparison to the market benchmark.
/ C
The idea of M squared refers to one of the most recent modern portfolio
E
measuring techniques, Franco Modigliani and Leah Modigliani originally
D C
introduced M squared in 1997. They put forth Risk Adjusted Performance
as an alternative performance measure that takes risk into account.
©D
The idea behind risk adjusted performance is to use the market’s
opportunity cost of risk, or trade-off between risk and return, to adjust
every portfolio to the unmanaged market benchmark’s level of risk,
matching each portfolio’s risk to the market’s risk, and then measuring
the returns of this risk-matched portfolio.
PAGE 181
Notes The M squared formula is as follows:

⎧ Return of portfolio − return of the benchmark ⎫
M2 =⎨ × Benchmark risk ⎬ + return of the benchmark
⎩ portfolio risk ⎭
When a portfolio has the same portfolio as the market, M2 calculates the
difference between its excess return over the market. In contrast to the
Sharpe ratio, which measures return vs. risk in units, M2 is expressed as
a percentage return, making it simpler for investors to understand when
examining a portfolio.
h i
Illustration: Portfolio A offer return of 21% with a 28% standard
e l
D
deviation, while portfolio B offer returns of 22% with a 38% standard
of
deviation. The market benchmark showed a 15% return with an 20%
standard deviation. The return on the risk-free rate was 2.0%. Calculate
ty
the M squared for Portfolio A and Portfolio B.
Solution: The M squared formula is as follows:
s i
e r
⎧ Return of portfolio − return of the benchmark ⎫
v
M2 =⎨ × Benchmark risk ⎬ + return of the benchmark
i
⎩ portfolio risk ⎭
M squared for Portfolio A:

U n
M2= {21%28%− 4% × 20%}L+ 4%,
S O
= 12.14% + 4%
L /
O
= 16.14 %
/ C
M squared for Portfolio B:
E{ 22% − 4%
}
DC
M =2
× 20% + 4%
38%
©D
= 9.48% + 4%
= 13.48%
From the above figures, we can infer that although while portfolio
B’s absolute return of 22.0% is higher than portfolio A’s of 21%. But
portfolio A’s M2 is actually 16.14% is higher than that of B’s portfolio
M2 of 3.48%.
182 PAGE
Measures of portfolio performance are important in making investment Notes

decisions. These tools give investors the knowledge they need to evaluate
how well their money has been invested (or might be invested), as well
as potential investments. Keep in mind that portfolio results only tell a
portion of the tale. Investors cannot reasonably perceive the full investing
picture without considering risk-adjusted returns, which may unintentionally
result in confused decisions.
7.5 Return Attribution

h i
e l
D
A sophisticated tool for assessing a portfolio manager’s or fund manager’s
of
performance is attribution analysis. It also known by the names “return
attribution” or “performance attribution,” and it aims to discover sources
ty
of excess returns, especially when compared to an index or other
i
benchmark, by statistically analysing various aspects of an active fund
s
r
manager’s investment choices and decisions. Return attribution offers
e
v
asset management companies quality control for the investment process
n i
by highlighting important strengths and weaknesses crucial to managing
U
a complex business with many investment strategies.
,
Three elements are the subject of attribution analysis: the manager’s
L
O
investment choices and asset allocation, their investing approach, and the
S
timing of their trades and decisions relative to the market. The process
L /
starts by determining the asset class that a fund management decides to
O
invest in. An asset class, in general, specifies the kinds of investments
/ C
that a manager selects; within that, it can also go more precise, specifying
E
the region from which they come or the industry sector in which they
operate.
D C
Return attribution also offers data that is useful for analysing investment
©D
management ability, which is the focus of performance evaluation. Assume
that a portfolio’s return for the last year was 7% and that its benchmark
return was 10% for the same time frame. In this instance, the portfolio
generated a negative arithmetic return of 3% over the previous year
(7% – 10% = –3%). After this, return attribution can be used to find out
the reason of deviation and how actual return fall short of 3%. Attribution
analysis can be a useful technique for portfolio managers and investment
firms to evaluate strategies. Attribution analysis can be used by investors
PAGE 183
Notes to evaluate the efficacy of fund or money managers like – Was the return
obtained by avoiding benchmark assets that performed comparatively
poorly or by choosing securities that performed well in comparison to
the benchmark (security selection)? Or was the return obtained through
the choice to overinvest in a specific economic sector or asset category
that underperformed the overall benchmark for that time period?
When performance is poor, return attribution analysis is especially
i
crucial because portfolio managers must show that they understand their
l h
performance, justify their choices, and inspire confidence in their capacity
e
to continue adding value in the future. The feedback mechanism of the
D
portfolio management process includes return attribution, which quantifies
of
the active decisions made by portfolio managers, monitors consistency,
and informs senior management and clients. Return attribution can be
ty
considered a “backward-looking” or ex post feedback mechanism because
s i
it is used to assess investment choices made over a specific historical
e r
time horizon. By using return attribution, we may determine whether
i v
investment choices, in relation to the portfolio’s benchmark, have increased
U n
or decreased value over a given time horizon.
Importance of return attribution analysis
L ,
Return attribution analysis was initially created as a portfolio management
O
tool, but it is equally beneficial for senior management, client relationship
S
L /
specialists, risk controllers, operations staff, sales and marketing professionals,
as well as clients and potential clients.
C O
For managers of portfolios it is a useful tool for evaluating strategies. It
E /
provides managers with the chance to evaluate every step of the investment
C
decision-making process and identify areas for improvement. The tool
D
that transforms performance measurement data from the back office into
©D
data that is helpful to the middle office control function is, in essence,
return attribution analysis. A thorough understanding of the investment
decision-making process is necessary for effective return attribution
analysis, and return attribution must take the active decisions of the
portfolio manager into account. Also at an asset management company,
it is also used to assess staff performance. If an analyst or employee
advised overweighting a certain industry or purchasing a specific stock,
the profits might be ascribed to their efforts, which could be used to
reward and inspire them further.
184 PAGE
It is an efficient method for investors to evaluate the performance of fund Notes

managers. Attribution analysis is a crucial tool for investors and clients
of portfolio managers to evaluate a manager’s performance and determine
whether their investment strategy and personal investing preferences
have been followed. A portfolio manager may have underweighted the
appropriate sector but chosen high-return stocks, demonstrating that
selection rather than allocation is their stronger suit. In a similar vein, a
portfolio manager might consent to create a portfolio with little risk. In
order to promote transparency and reassure investors that the risk-averse
h i
strategy is being applied, the allocation and selection procedures should
e l
D
be examined.
of
Overall, it is the instrument that enables performance analysts to provide
value and take part in the investment decision-making process by identifying
ty
the sources of excess return. A successful return attribution procedure
s i
must: reconcile to the overall portfolio return; reflect the investment choice
e r
process; quantify the active decisions made by the portfolio manager;
i v
and offer a thorough understanding of the excess return of the portfolio.
U n
Any discrepancies found in the return attribution computation would
unavoidably draw a lot of notice given its central position in the analysis
L ,
of the investment decision process. To guarantee that the return attribution
O
analysis accurately reflects the decision process and that the data is of
/ S
acceptable quality, considerable work may be necessary. Naturally, residuals
O L
of any size will cast doubt on the reliability of the return attribution
analysis. In order to give useful information, the return attribution analysis
/ C
may need to be redesigned to account for a new decision-making step,
E
instrument, or strategy.
C
D
IN-TEXT QUESTIONS
©D
1. The best way to sum up return attribution is as a procedure
that:
(a) Tracks the outcomes of an active portfolio manager’s choices
(b) Aids in the creation of an investment plan by a portfolio
manager
(c) Evaluates the adequacy of the allocation or selection choices
made by the portfolio manager
PAGE 185
Notes 2. The optimal application of return attribution is to:

(a) Gauge portfolio volatility
(b) Evaluate the value that active investment choices offer
(c) Make performance returns account for outside cash flows
(d) All of these
3. Which of the following statements most accurately sums up the
role that performance evaluation plays in asset management?
h i
l
Performance assessment:
D e
(a) Offers knowledge that significantly lowers risk
of
(b) Assists investment managers in aligning portfolios with
the goals of asset owners by providing feedback
i ty
(c) The asset owner reporting function, which only happens
s
at the end of the management process
e r
i v
4. The best way to define performance measurement is:
U n
(a) An assessment of a manager’s investment ability
L ,
(b) Identifying the causes of an excess return relative to a
O
benchmark in a portfolio
/ S
(c) Assessing the risk and return measures for a portfolio
O L
/ C
E
D C A portfolio management activity would be lacking without regular reviews.
©D
Investors must continuously evaluate their chosen portfolio after making
their selection to make sure that it maintains its optimal status throughout
time. The appealing securities could stop offering viable returns due to
dynamic changes in the economy and financial markets. New securities
that promise large returns at low risks are produced as a result of the
market shifts. In these circumstances, the investor must make changes
to their portfolio by selling their old stocks and purchasing new ones.
The mix and proportion of securities in the portfolio vary as a result of
portfolio adjustment.
186 PAGE
Revision of a portfolio entails altering the current security mix. Altering Notes
the securities currently included in the portfolio or the percentage of
cash invested in the securities can accomplish this. The portfolio may
contain new securities as well as current securities that are removed or
added in new quantities. As a result, stock purchases and sales result
from portfolio adjustment.
The portfolio, once chosen, must be continuously reviewed over time and,
i
if necessary, revised depending on the investor’s objectives. Changing
the asset allocation of a portfolio is what is meant by portfolio revision.
l h
e
The process of portfolio revision entails altering the mix of stocks or
bonds in the portfolio based on performance, expectations, and strategy.
D
of
Stocks should be updated if an investor’s strategy changes from capital
appreciation to earnings.
i ty
The goal of portfolio revision is to maximise return for a given level of
r s
risk or to minimise risk for a given level of return, which is the same
e
goal as portfolio selection. The maximisation of returns and the reduction
v
i
of risk are the ultimate goals of portfolio revision.
n
U
The frequency of review, however, depends on the size of the portfolio,
,
the amount at stake, the type of securities held, and the investor’s time
O L
constraints. The evaluation should be followed by appropriate and timely
action and should involve a detailed examination of investment objectives,
/ S
targets for portfolio performance, actual results obtained, and analysis of
cause for variances.
O L
C
Reasons for Revision of Portfolio
E /
1. A person might feel the urge to invest more money at one point
D C
in time. When a person has some extra cash to invest, a portfolio
adjustment is necessary.
©D
2. A portfolio modification may also result from a change in investing
objectives. Depending on the cash flow, a person might change
his financial objective, which finally results in adjustments to the
portfolio.
3. There are dangers and unpredictability in the financial market. A
person may sell off some of his assets as a result of changes in
the financial market.
PAGE 187
Notes Portfolio Review Techniques

An active revision strategy and a passive revision strategy are the two
options available for portfolio revision. The objectives, expertise, money,
and time of the investor would all play a role in the strategy’s choosing.
Portfolio Revision Strategies come in two different varieties.
Active Revision Technique
For optimum returns and minimal risks, an active revision strategy entails
making regular adjustments to an existing portfolio over a set period of
h i
l
time. A portfolio manager can revise their portfolio by regularly selling
e
D
and buying assets with the aid of an active revision strategy. Investors
of
that use active revision strategies think that markets for securities are
not always efficient. They contend that mispriced securities occasionally
ty
present an opportunity for trading in them to generate excess returns. In
i
addition, they think that many investors have varying or heterogeneous
s
r
expectations about the risk and return of securities available on the
e
market. Active revision strategists are certain that they will produce more
v
i
accurate estimations of the real risk and return of assets than the rest
n
U
of the market. They intend to produce excess returns using their more
,
accurate estimates. Therefore, the goal of an active revision strategy is
L
to outperform the competition.
O
S
The portfolio managers adjust the cash position or beta of the equity
/
element of the portfolio in accordance with market forecasts, which is
L
O
holding securities based on future expectations. Reperforming portfolio
C
analysis and portfolio selection is the essence of active portfolio revision.
E /
It is based on a consideration of both technical elements like demand
C
and supply and fundamental issues impacting the economy, industry,
D
and business. Therefore, the time, expertise, and resources needed for
©D
active revision plan implementation will be significantly higher. Under
an active revision method, trading is expected to occur more frequently,
which would raise transaction costs.
Passive Revision Techniques
It involves using a buy-and-hold strategy to hold a well-diversified portfolio
over an extended period of time. Additionally, it describes the investor’s
effort to put together a portfolio that closely resembles the overall market
returns. A portfolio manager may only make adjustments to the portfolio
188 PAGE
in accordance with the formula plans, according to the passive revision Notes
approach. Under a passive revision method, changes to the portfolio
are made in accordance with a set of predetermined guidelines known
as formula plans. The investor can modify his portfolio in response to
developments in the securities market with the use of these formula plans.
Rare modifications in the portfolio are permitted under the passive revision
strategy’s rules. In contrast to active revision technique, a passive revision
i
technique over time simply makes small and infrequent adjustments to the
portfolio. The advocates of the passive revision technique claim that the
l h
e
expectations of investors are uniform and the market is efficient. They
see no reason to actively trade and regularly review their investments.
D
of
Both active and passive portfolio updating strategies are used by investors.
The efficient market hypothesis is slowly but steadily gaining support,
i ty
according to studies on portfolio revision techniques, and investors are
r s
revising their portfolios considerably less frequently than they were in
e
the past due to their growing confidence in market efficiency.
v
i
It is necessary to buy and sell assets in order to make a portfolio
n
U
modification or adjustment. There are several issues that arise from
,
the practise of portfolio adjustment, which involves buying and selling
O L
securities, and which operate as limitations on portfolio revision. Here
are a few of these: Firstly, there are charges associated with buying and
/ S
selling stocks, such as commission and brokerage. The advantages from
O L
portfolio revision may be diminished if securities are often bought and
sold for portfolio revision purposes. Therefore, the transaction costs
/ C
associated with portfolio change may serve as a barrier to timely portfolio
E
adjustment. Secondly, the institutional investors like investment firms and
C
D
mutual funds company are typically subject to statutory/legal restrictions
©D
on their investment activities. These requirements frequently serve as
restrictions on fast portfolio revision.
Thirdly, revision of a portfolio is a challenging and time-consuming task.
It is also unclear what process should be used for portfolio revision.
Different strategies could be used to achieve the goal. Portfolio revision
may be hampered by how difficult it is to actually carry it out. Lastly,
capital gains from the selling of securities are subject to taxation. Short-
term capital gains are often taxed at a higher rate than long-term capital
gains. Securities must be owned by an investor for at least 12 months
PAGE 189
Notes prior to selling in order for the sale to qualify as a long-term capital gain.
Periodic portfolio revisions or adjustments that involve frequent sales of
stocks will produce short-term capital gains, which are taxed more heavily
than long-term capital gains. The increased tax rate on short-term capital
gains could make it more difficult to make regular portfolio adjustments.
7.7 Summary
The measurement, analysis, interpretation, appraisal, and presentation
h i
e l
of investment results are all parts of what is referred to as performance
D
evaluation in the investment management sector. Performance evaluation
of
in particular offers details on the return and risk of investment portfolios
over predetermined time frames. A subject that is closely connected is the
ty
choice of investment managers. Monitoring targets versus actual results
i
to determine how well the company and its personnel are performing
s
r
both collectively and individually is very important. Longer-term goals
e
v
(like customer happiness) and short-term goals (like cost containment)
n i
can both be related to performance assessments.
, U
This unit also makes the point that to reach your financial objectives, it’s
imperative to evaluate your investment portfolio. You can rebalance your
O L
portfolio in accordance with your life goals and events with the aid of
S
timely assessments and thorough feedback from a qualified professional.
L /
Performance of an investment portfolio can take many forms, and no
O
single strategy is ideal.
/ C
New techniques and research on evaluating investment performance have
C Eexploded in recent years. In order to account for variations in risk levels

between the managed portfolio and the benchmark portfolio, risk-adjusted
D approaches modify returns. The Sharpe ratio, Treynor ratio, Jensen’s alpha,
©D
Modigliani and Modigliani are the principal techniques. The risk-adjusted
approaches are favoured above the traditional approaches.
Building a flawless portfolio that enables you to generate money over
the short, medium, and long terms is ultimately the aim of portfolio
review. We have learned in this unit that portfolio revision, which entails
modifying the current mix of assets, is just as crucial to the portfolio
management process as portfolio analysis and selection. Investors’ portfolio
revision techniques can be roughly divided into “active” and “passive”
190 PAGE
revision techniques. Those who believe in market efficiency or who lack Notes
the resources and expertise for portfolio analysis and selection will use
both “active” and “passive” revision tactics.
All performance analysts need return attribution as a tool. Return
attribution is a crucial tool for making sure portfolio returns are calculated
accurately, facilitating communication between portfolio managers and
clients, creating a true understanding of the sources of value added and
i
subtracted from the portfolio, and enabling performance analysts to take
h
part in the investment decision-making process and thereby add value.
e l
D
1. (a) Tracks the outcomes of an active portfolio manager’s choices
of
2. (b) Evaluate the value that active investment choices offer
i ty
r s
3. (b) Assists investment managers in aligning portfolios with the
goals of asset owners by providing feedback
v e
n i
4. (c) Assessing the risk and return measures for a portfolio

, U
O L
1. Define optimal portfolio. How is it important in investment decisions?
/ S
L
2. What is Portfolio Revision?
O
3. List major reasons that could drive a review of portfolio.
/ C
4. What safety measures and cautions ought a financial manager to
E
exercise when making investment-related decisions?
C
D
5. Differentiate between “active” and “passive” portfolio revision
©D
strategies.
6. What procedures do we follow in order to choose the finest portfolio?
7. What are risk-adjusted methodologies and portfolio performance?
8. Describe the constraints faced while making alterations in the portfolio.
9. What factors influence the performance of a portfolio?
10. Why is a portfolio revision necessary? What limitations apply to
the updating of a portfolio?
11. Briefly describe the techniques for calculating portfolio returns.
PAGE 191
Notes 12. Describe Treynor’s Measure, Jensen’s Differential Return, and Sharpe’s
Ratio.
13. Below are three portfolios’ rates of return and standard deviations:
Portfolio Rate of Return Standard Deviation
Market 16% 1.95
A 15% 0.13
B 19% 0.17
C 18% 0.18
h i
e l
The risk-free rate is 0.10. The market’s (M) systematic risk is 1.5
D
and its (M) rate of return is 18%. Calculate the Sharpe ratio.
of
14. Information including return rate and beta on three funds, DEE,
RNK, and PRI is available. 10% is the risk-free rate. Market (M)
ty
has an 16% rate of return and a risk of (1.5) per cent.
s i
r
Rate of Return Beta
Market
v e16% 0.80
DEE
n i 14% 0.70
U
RNK 18% 0.85
,
PRI 20% 1.00
L
Determine the value of three funds- DEE, RNK and PRI using the Treynor
O
S
method.
L /
O
7.10 References
/ C
E
Allen, Gregory C. 1991. “Performance Attribution of Global Equity
C
Portfolios.” Journal of Portfolio Management, Vol. 18, No. 1 (Fall):
D
59–65.
©D
Aragon, O.G., & W.E. Ferson (2006). Portfolio Performance
Evaluation, Foundations and Trends in Finance, 2(2), pp. 83–190.
DOI: 10.1561/0500000015.
Bacon, Carl R. (2019). Performance Attribution History and Progress.
CFA Institute Research Foundation. p. 42.
Del Guercio D, Tkac PA. 2002. The Determinants of the Flow of
Funds of Managed Portfolios: Mutual Funds vs. Pension Funds.
Journal of Financial and Quantitative Analysis. 37(4): 523–57.
192 PAGE
Fischer, Bonald E, and Ronald J. Jordon, 1995, Security Analysis Notes

and Portfolio Management, 6th PHI, New Delhi.
Frederick Amling, Investments: An Introduction to Analysis and
Management, 5th Ed., Prentice Hall, N.J.
Grinblatt M, Titman S. 1989b. Portfolio Performance evaluation: old
issues and new insights. Review of Financial Studies 2: 393–422.
Jensen, M.C. (1968). The performance of mutual funds in the period
1945–1964. Journal of Finance, 23: 389–416.
h i
Jones, C.P. (2009). Investments: Analysis and Management (11th ed.),
e l
D
New Jersey: John Wiley & Sons.
of
Markowitz H. (1952). Portfolio selection, The Journal of Finance,
7(1), pp. 77–91.

i ty
Reilly, F., K. Brown, & S. Leeds (2018). Investment Analysis and
r s
Portfolio Management, 11th edition, Cengage Learning, Inc.

v e
Sharpe, W.F. (1966). ‘‘Mutual fund performance.’’ Journal of Business,
39(1): 119–138.
n i
U
Sharpe, W.F. (1992). ‘‘Asset allocation: management style and
7–19.
L ,
performance measurement.’’ Journal of Portfolio Management, 18:
S O
Treynor, J.L. (1965). ‘‘How to rate management of investment
/

L
funds.’’ Harvard Business Review, 43: 63–75.
C O
/

C E
Bhattacharya S, Pfleiderer P. 1985. Delegated portfolio Management.
D
Journal of Economic Theory. 36: 1–25.
©D
Bodie, Kane, and Marcus (2020). Investments, McGraw Hill, 11th
edition. Especially Part VII, Chapters 24–28.
Carino D, Christopherson J, Ferson W. 2009. Portfolio Performance
Measurement and Benchmarking. McGraw Hill Books.
Chen Z, Knez PJ. 1996. Portfolio performance Measurement: theory
and applications. Review of Financial Studies. 9: 511–56.
PAGE 193
Notes Edwin J. Elton, Martin J. Gruber, Stephen J. Brown, and William

N. Goetzmann (2014). Modern Portfolio Theory and Investment
Analysis, 9th edition, Wiley. Pages 731.
Frank K. Reilly and Keith C. Brown (2012). Investment Analysis
& Portfolio Management, Tenth Edition, South-Western, Cengage
Learning. Pages 1045.
h i
e l
D
of
i ty
r s
v e
n i
, U
O L
/ S
O L
/ C
C E
D
©D
194 PAGE
Glossary
Active Portfolio Management: In an effort to surpass a benchmark or generate greater
returns than a passive investment strategy, active portfolio management is a method in
which portfolio managers actively choose which investments to make. The goal of active
portfolio management is to take advantage of market mis-pricings by continuously analysing,
i
researching and trading.
l h
Arbitrage: The practise of profiting risk-free from price differences between several
D e
marketplaces or securities. Arbitrageurs take advantage of price discrepancies by purchasing
undervalued assets in one market and simultaneously selling them at higher prices in a
of
different market, doing so until equilibrium is reached.
ty
Arbitrage Pricing Theory (APT): An alternative asset pricing model that takes into account
i
various risk factors and how they affect asset returns is called Arbitrage Pricing Theory
s
r
(APT). Contrary to the CAPM, the APT does not presume that the market is efficient and
allows for the possibility of arbitrage opportunities.
v e
n i
Asset Management: The management of collective investments is frequently referred to
U
as asset management.
L ,
Asset Pricing: Stocks, bonds, and derivatives are just a few examples of financial assets
O
that are valued according to their expected returns and risk in the area of finance known
S
as asset pricing.
L /
Benchmark: A benchmark is a standard or point of comparison used to assess how well
O
an asset or investment portfolio has performed. Market indices or unique portfolios that
C
/
represent a certain investment strategy or asset class can serve as benchmarks.
E
C
Benchmark Portfolio: A portfolio against which an investor can evaluate the overall
D
performance of the investments made by him.
©D
Beta: A measurement of how sensitive a stock is to changes in the market. The CAPM
uses beta to calculate an asset’s projected return in relation to the market as a whole. A
beta value larger than 1 indicates greater market volatility, whereas a beta value less than
1 suggests reduced market volatility.
Capital Asset Pricing Model: CAPM is an extension of Capital Market Theory which is
used to predict the expected return on a security or portfolio.
Capital Market: It is a financial market which brings buyers & sellers together to trade
financial assets having a maturity period of more than one year.
PAGE 195
Notes Capital Market Line: The efficient portfolios are obtained by combining
the optimal portfolio of risky assets with risk-free lending or borrowing.
Covariance: It is a statistical tool which measures the extent of interaction
between two random variables.
Diversification: Spreading investments across several assets or asset
classes in order to lower risk is known as diversification. By integrating
assets with low or negative correlations, diversification tries to reduce
i
the impact of individual asset performance on the total portfolio. It is a
cornerstone idea of portfolio management.
l h
D e
Dividend Yield: Annual percentage of return earned by a share. The
of
yield is determined by dividing the amount of the annual dividends per
share by the current net asset value or public offering price.
ty
Efficient Frontier: The set of efficient portfolios.
s i
Efficient Market: A market that fully reflects all information is said
e r
to be efficient, making it impossible for investors to regularly generate
i v
anomalous or excessive returns. Rapid price changes in response to new
U n
information are a hallmark of efficient markets, making it difficult to
identify assets that are being mispriced.
L ,
Equities: Shares issued by a company which represent ownership in
O
it. Ownership of property, usually in the form of common stocks, as
/ S
distinguished from fixed-income securities such as bonds or mortgages.
O L
Stock funds may vary depending on the fund’s investment objective.
Equity Fund: A mutual fund/collective fund in which the money is
/ C
invested primarily in common and/or preferred stock. Stock funds may
C Evary, depending on the fund’s investment objective.
D
Expected Return: The expected gain or return on an investment based
©D
on a number of variables, including past performance, risk, and upcoming
market circumstances. The expected return is used to determine how
appealing an investment offer is.
Extensions of Capital Asset Pricing Model: The traditional CAPM has
undergone a number of changes and improvements to take into account
new variables or complex asset pricing issues. In these extensions, elements
like size, value, momentum, and other market oddities may be present.
196 PAGE
GLOSSARY
Fixed Income Fund: A fund or portfolio where bonds are primarily Notes
purchased as investments. There is no fixed maturity date and no repayment
guarantee.
Fund Performance: In the institutional setting, precise assessment is
essential. Fund performance is the litmus test for fund management.
Fundamental Analysis: It is an attempt to determine the intrinsic value
of a security and compare it with a current market price which helps in
i
investment decision-making in terms of whether to buy or not to buy the
securities at the current prevailing prices.
l h
D
Idiosyncratic Risk: Idiosyncratic risk, sometimes referred to as unsystematic
e
of
risk or diversifiable risk, is a type of risk that is unique to a particular
business or asset and can be mitigated by diversification. Examples of
ty
factors that affect the performance of a specific asset include company-
specific events, management choices or industry-specific factors.
s i
r
Indifference Curve: It shows the utility score of an investor in terms
e
v
of expected returns and risk. All the points on a particular IC represent
n i
different levels of risk and return with the same amount of satisfaction.
, U
Investment: The phrase “investment” or “investing” has a number of
closely related meanings in business management, finance, and economics
O L
that have to do with saving money or putting off buying things.
/ S
Investment Management: Is the professional management of a variety
O L
of assets (such as real estate) and securities (such as shares, bonds, etc.)
to achieve certain investment objectives for the benefit of investors.
/ C
Market Efficiency: The extent to which market prices accurately and
E
immediately reflect all available information. Strong form efficiency,
C
D
semi-strong form efficiency, and weak form efficiency are the three types
©D
of market efficiency. For active portfolio managers looking to routinely
outperform the market, efficient markets provide difficulties.
Mispricings: Situations where an asset’s market price differs from its
true or inherent value. Various reasons, such as market inefficiencies,
investor mood, or insufficient information, might lead to mispricings. To
make money, traders and investors try to take advantage of mispricings.
Momentum Effect: A phenomena in which investments that have performed
well in the past continue to do so in the future, whereas investments that
PAGE 197
Notes have performed poorly in the past continue to underperform. The efficient
market hypothesis is refuted by the momentum effect.
Optimal Portfolio: According to the optimal portfolio, investors will
make rational decisions that always try to maximise their return for their
tolerable level of risk.
Passive Investment Strategy: Investors who use a passive investment
approach seek to mimic the performance of a market or a particular index
i
rather than actively choosing individual investments. Exchange-traded
funds (ETFs) or low-cost index funds are frequently used in passive
l h
investment techniques.
D e
of
Portfolio: A portfolio is a collection of financial investments held by
a person or an organisation, such as stocks, bonds and other securities.
ty
Portfolios are built to accomplish particular financial goals, such as capital
growth, income production or risk reduction.
s i
r
Portfolio Allocation: Amount of assets in a portfolio specifically designated
e
v
for a certain type of investment.
n i
Portfolio Analysis: Determining risk and return while identifying a variety
U
of potential portfolios from a different set.
,
L
Portfolio Evaluation: Comparison between objective norms and relative
O
performance in portfolio evaluation. provides a channel for feedback to
/ S
help the portfolio management process as a whole.
L
Portfolio Holdings: Investments included in a portfolio.
O
C
Portfolio Manager: The person or entity responsible for making investment
E /
decisions of the portfolio to meet the specific investment objective or
C
goal of the portfolio.
D Portfolio Revision: Portfolio management is an ongoing process, that
©D
requires continuous monitoring of the portfolio to keep track of any
changes that take place concerning risk and return profile and price levels
of the individual securities with the change in the financial environment
which in turn bring a change in the portfolio risk and return profile.
Portfolio Selection: An effective portfolio is found, and the best portfolio
is chosen.
Risk-Averse: Investors that select lower-risk investments and are more
focused on preserving capital than maximising returns are said to be
198 PAGE
GLOSSARY
risk-averse. Investors that are risk-averse often look for assets with lower Notes
volatility or better-expected returns compared to risk.
Risk-Averse Investor: An investor who prefers a low degree of risk
and hence, tends to avoid investment in relatively risky financial assets.
Risk-Free Asset: An asset whose returns are certain and known at the
beginning of the holding period.
Risk Factors: Risk factors are variables or elements that influence an
investment’s performance or value. Economic indicators, market conditions,
h i
industry-specific factors, and company-specific factors are all examples
e l
D
of risk factors. Risk considerations are used in asset pricing models to
of
calculate projected returns and assess risk.
Risk Premium: Risk premium is the additional return anticipated from an
ty
investment over and above the return on a risk-free investment. Investors
s i
are compensated by the risk premium for taking on greater asset-related
r
risk. It is determined by elements like the volatility of the asset, market
e
v
circumstances and investor risk preferences.
n i
Security Analysis: Classification of securities (shares, debentures, bonds,
, U
etc.), examination of the risk-return characteristics of specific securities,
fundamental analysis, and technical analysis are all parts of security
analysis.
O L
/ S
Security Market Line: Security market line is the graphical representation
O L
of the CAPM. It exhibits the expected return on security as a function
of systematic risk or non-diversifiable risk.
/ C
Size Effect: The finding that, even when risk is taken into account, smaller
E
businesses consistently outperform their larger counterparts over the long
C
D
term. This result casts doubt on the CAPM’s premise that projected returns
©D
are exclusively a function of market risk.
Standard Capital Asset Pricing Model (CAPM): A popular financial
model that determines an asset’s expected return based on its beta, or
measure of market sensitivity. The CAPM makes the suppositions that
the market is efficient and that investors are risk averse.
Systematic Risk: Systematic risk, sometimes referred to as market risk
or non-diversifiable risk, is the term for risk elements that have an
impact on the entire market or a particular industry. Individual investors
PAGE 199
Notes cannot manage these risks, and diversification cannot eliminate them. The
projected returns on assets are impacted by systematic risk.
Value Effect: The propensity of equities with low price-to-book ratios or
other value indicators to outperform those with high ratios is known as
the “value effect.” The CAPM’s premise that market risk alone determines
expected returns is in conflict with this effect.
Volatility: A measurement of how much an asset’s price fluctuates or
i
varies. Greater volatility translates into wider price fluctuations and higher
l h
risk. Volatility affects projected returns and risk assessments, making it
a key component in asset pricing models.
D e
of
i ty
r s
v e
n i
, U
O L
/ S
O L
/ C
C E
D
©D
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Editorial Board

Prof. Amit Kumar Singh

© Department of Distance and Continuing Education

Corrections/Modifications/Suggestions proposed by Statutory Body, DU/

© Department of Distance & Continuing Education, Campus of Open Learning,

Lesson 1 : Introduction to Financial Investments

Lesson 3 : Fixed Income

Lesson 5 : Modern Portfolio Theories

Lesson 6 : Asset Pricing

Lesson 7 : Evaluation of Investment Performances

Notes  To understand the process of investment decisions.

Research and Analysis: Successful investment frequently necessitates Notes

Notes Diversification: To reduce risk, diversify your investments among industries,

D It is critical to understand that the investment process necessitates

1.5 Avenues of Investment

Stocks (Equities): Investing in publicly traded company shares. Stocks Notes

estate without physically owning properties.

Notes Peer-to-Peer Lending: Investing in loans to individuals or small businesses

C Edynamics that influence investment decision-making and outcomes. These

D returns, hazards, and overall success. Economic conditions, market trends,

C E intrinsic or fair value. They believe that markets misprice assets

sometimes entails investing in dividend-paying stocks, bonds, real Notes

C E you to severe risk if that investment underperforms.

8. “Don’t chase performance”: Just because an investment has Notes

Notes IN-TEXT QUESTIONS

© D (c) Individual stock

(c) There is no relationship between risk and potential return Notes

(d) Risk and potential return are independent factors

Notes Important Points:

C Echosen should correspond to an investor’s risk tolerance, goals, and time

Notes 4. Explain the Concept of philosophies of Investment.

D C  Bodie, Z., Kane, A. & Marcus, A. J. (2017). Investments. New York:

 Holden, C. W. (2014). Excel Modeling in Investments. England: Notes

2.1 Learning Objectives Notes

 To understand the relationship between prices of the stock and the

Notes 2.3 Fundamental Analysis

C OValuation based on accounting information

E / Valuation based on dividend

D D 2.4.1 Valuation Based on Accounting Information

D 0 (1+ g 1 ) D5 (1+ g 2 ) D10 (1+ g 3 )

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2.4.3 Valuation Based on Earnings

The value of equity share is given by:

D maximise the value of the equity share.

2.5.1 Active Strategy

D D the investor has to carefully select the particular index fund.

© 2.6 Technical Analysis

Notes Indicators: Indicators are a mathematical output of various calculations

D D (c) Move randomly

(a) Slanting lines

2.7 Market Efficiency and Anomalies

2.7.1 Weak Form of Market Efficiency

2.7.2 Semi-strong Form of MarketsEfficiency

2.7.3 Strong Form of Market Efficiency

Notes 2.8 Summary

/ Cholding of the equity share.

© D  As per Gordon’s model, the value of equity share is given by:

 As per Walter’s model, P0 = D + r k e (E − D)

Notes To understand the process of investment decisions.

D C Bodie, Z., Kane, A. & Marcus, A. J. (2017). Investments. New York:

Holden, C. W. (2014). Excel Modeling in Investments. England: Notes

To understand the relationship between prices of the stock and the

E / Valuation based on dividend

7KH YDOXH RI HTXLW\ VKDUH LV ൗ

© D As per Gordon’s model, the value of equity share is given by:

As per Walter’s model, P0 = D + r k e (E − D)

Notes Investor Knowledge and Expertise: Investing in commodities