Unit – V

Unit Structure

Lesson 5.1 - Capital Asset Pricing Theory

Lesson 5.2 - Arbitrage Pricing Theory
Lesson 5.3 - Portfolio Evaluation
Lesson 5.4 - Portfolio Revision

Learning Objectives

After reading this chapter, students should

➢➢ 
Understand the concept of CAPM.
➢➢ 
Know about the APT various types of futures contracts like interest rate futures,
foreign currency futures, stock index futures, bond index futures, etc.
➢➢ 
Understand the portfolio revision

Lesson 5.1 - Capital Asset Pricing Theory

Introduction

Investors are interested in knowing the systematic risk when they search for efficient
portfolios. They would like to have assets with low beta co-efficient i.e. systematic risk.
Investors would opt for high beta co-efficient only if they provide high rates of return. The
risk averse nature of the investors is the underlying factor for this behavior. The capital
asset pricing theory helps the investors to understand the risk and return relationship of the
securities. It also explains how assets should be priced in the capital market.

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The CAPM Theory

Markowitz, William Sharpe, John Lintner and Jan Mossin provided the basic
structure for the CAPM model. It is a model of linear general equilibrium return. In the
CAPM theory, the required rate return of an asset is having a linear relationship with asset’s
beta value i.e. undiversifiable or systematic risk.

Assumptions

1. An individual seller or buyer cannot affect the price of a stock. This assumption is
the basic assumption of the perfectly competitive market.

2. Investors make their decisions only on the basis of the expected returns, standard
deviations and co variances of all pairs of securities.

3. Investors are assumed to have homogenous expectations during the decision-making

period.

4. The investor can lend or borrow any amount of funds at the riskless rate of interest.
The riskless rate of interest is the rate of interest offered for the treasury bills or
Government securities.

5. Assets are infinitely divisible. According to this assumption, investor could buy any
quantity of share i.e. they can even buy ten rupees worth of Reliance Industry shares.

6. There is no transaction cost i.e. no cost involved in buying and selling of stocks.

7. There is no personal income tax. Hence, the investor is indifferent to the form of
return either capital gain or dividend.

8. Unlimited quantum of short sales is allowed. Any amount of shares an individual can
sell short.

Lending and Borrowing

Here, it is assumed that the investor could borrow or lend any amount money at
riskless rate of interest. When this opportunity is given to the investors, they can mix
risk free assets with the risky assets in a portfolio to obtain a desired rate of risk-return
combination.

Rp = Portfolio return
Xf = the proportion of funds invested in risk free assets

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 1- Xf = the proportion of funds invested in risky assets
Rf = Risk free rate of return
Rm = Return on risky assets

The expected return on the combination of risky and risk free combination is

Rp = RfXf + Rm(1 – Xf )

This formula can be used to calculate the expected returns for different situations,
like mixing ri assets with risky assets, investing only in the risky asset and mixing the
borrowing with risky assets.

Now, let us assume that borrowing and lending rate to be 12.5% and the return from
the risky assets to be 20%. There is a trade off between the expected return and risk. If an
investor invests in risk free assets and risky assets, his risk may be less than what he invests
in the risky asset alone. But if he borrows to invest in risky assets, his risk would increase
more than he invests his own money in the risky assets. When he borrows to invest, we call
it financial leverage. If he invests 50% in risk free assets and 50% in risky assets, his expected
return of the portfolio would be

Rp = RfXf + Rm(1 – Xf )
= 12.5 x .5 + 20(1 - .5)
= 6.25 +10
= 16.25%
If there is a zero investment in risk free asset and 100% in risky asset, the return is

Rp = RfXf + Rm(1 – Xf )
= 0 + 20%
= 20%

If - .5 in risk free asset and 1.5 in risky asset, the return is

Rp = RfXf + Rm(1 – Xf )
= (l2.5 x -.5) + 20x 1.5
= -6.25 + 30
= 23.75

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The variance of the above mentioned portfolio can be calculated by using the equation.

σ 2p = σ2fX2f + σ 2m(1 – Xf )2 + 2CovfmXf(1 – Xf )

The previous example can be taken for the calculation of the variance. The variance of
the risk free asset is in. The variance of the risky asset is assumed to be 15. Since the variance
of the risky asset is zero, the 1,rtfolio risk solely depends on the portion of investment on
risky asset.

Proportion in risky asset (1-Xf ) Portfolio risk

0.5 1.0
1.5 7.5
1.5 22.5

The risk is more in the borrowing portfolio being 22.5% and the return is also high
among the three alternatives. In the lending portfolio, the risk is 7.5% and the return is also
the lowest. The risk premium is proportional to risk, where the risk premium of a portfolio
is defined as the difference between Rp - Rf i.e. the amount by which a risky rate of return
exceeds the riskless rate of return.

Risk - Return Trade Off

Portfolio Risk-free Risk Portfolio Factor of

Return Return Premium Risk Proportionality
Rp Rf Rp - Rf σ (Rp – Rf)/σp
16.25 12.5 3.75 7.5 0.5
20.0 12.5 7.5 15.0 0.5
23.75 12.5 11.25 22.5 0.5

The risk-return proportionality ratio is a constant .5, indicating that one unit of risk
premium is accompanied by 0.5 unit of risk.

The Concept

According to CAPM, all investors hold only the market portfolio and riskless
securities. The market portfolio is a portfolio comprised of all stocks in the market. Each
asset is held in proportion to its market value to the total value of all risky assets. For
example, if Reliance Industry share represents 20% of all risky assets, then the market

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portfolio of the individual investor contains 20% of Reliance industry shares. At this stage,
the investor has the ability to borrow or lend any amount of money at the riskiness rate of
interest. The efficient frontier of the investor is given in figure.

The figure shows the efficient frontier of the investor. The investor prefers any point
between B and C because, with the same level of risk they face on line BA, they are able to get
superior profits. The ABC line shows the investor’s, portfolio of risky assets. The investors
can combine riskless asset either by lending or borrowing. This is shown in Figure.

The line RfS represents all possible combination of riskless and risky asset. The ‘S’
portfolio does not represent any riskless asset but the line RS gives the combination of both.
The portfolio along the path RS is called lending portfolio that is some money is invested
in the riskless asset or may be deposited in the bank for a fixed rate of interest. If it crosses
the point S. it becomes borrowing portfolio. Money is borrowed and invested in the risky
asset. The straight line is called capital market line (CML). It gives the desirable set of
investment opportunities between risk free and risky investments. The CML represents

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linear relationship between the required rates of return for efficient portfolios and their
standard deviations.

E(Rp) = portfolio’s expected rate of return

Rm = expected return on market portfolio
σm = standard deviation of market portfolio
σp = standard deviation of the portfolio

For a portfolio on the capital market line, the expected rate of return in excess of the
risk free rate is in proportion to the standard deviation of the market portfolio. The price
of the risk is given by the slope of the line. The slope equals the premium for the market
portfolio Rm – Rf divided by the risk or standard deviation of the market portfolio. Thus, the
expected return of an efficient portfolio is

Expected return = Price of time + (Price of risk . Amount of risk)

Price of time s the risk free rate of return. Price of risk is the premium amount higher and
above the risk free return.

Security Market Line

The risk-return relationship of an efficient portfolio is measured by the capital

market line. But, it does not show the risk-return trade off for other portfolios and
individual securities. Inefficient portfolios lie below the capital market line and the risk-
return relationship cannot be established with the help of the capital market line. Standard
deviation includes the systematic and unsystematic risk. Unsystematic risk can be diversified
and it is not related to the market. If the unsystematic risk is eliminated, then the matter of
concern is systematic risk alone. This systematic risk could be measured by beta. The beta
analysis is useful for individual securities arid portfolios whether efficient or inefficient.

When an additional security is added to the market portfolio, an additional risk is

also added to it. The variance of a portfolio is equal to the weighted sum of the co-variances
of the individual securities in the portfolio.

If we add an additional security to the market portfolio, its marginal contribution

to the variance of the market is the covariance between the security’s return and market
portfolio’s return. If the security i am included, the covariance between the security and
the market measures the risk. Covariance can be standardized by dividing it by standard

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deviation of market portfolio coy im/σm. This shows the systematic risk of the security. Then,
the expected return of the security i is given by the equation:

Ri – Rf = (Rm – Rf/σm) Coy im/σm

This equation can be rewritten as follows

Ri – Rf = Coy im/σ2m (Rm – Rf)

The first term of the equation is nothing but the beta coefficient of the stock. The
beta coefficient of the equation of SML is same as the beta of the market (single index)
model. In equilibrium, all efficient and inefficient portfolios lie along the security market
line. The SML line helps to determine the expected return for a given security beta. In other
words, when betas are given, we can generate expected returns for the given securities. This
is explained in fig.

If we assume the expected market risk premium to be 8% and the risk free rate of
return tube 7%, we can calculate expected return for A, B, C and D securities using the
formula

E(Ri)= Rf + ßi[E(Rm)-Rf ]
If beta for ß = 1
If beta for = 1
= 7 + 1 (8)
= 15%

Security A
Beta = 1.10

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 E(R) =7+1.10(8)
= 15.8
Security B
Beta = 1.20
E(R) = 7 + 1.20(8)
= 16.8 = 16.6
Security C
Beta = .7
E(R) = 7 + .7(8)
=12.6

The same can be found out easily from the figure too. All we have to do is, to mark
the beta on the horizontal axis and draw a vertical line from the relevant point to touch the
SML line. Then from the point of intersection, draw another horizontal line to touch the Y
axis. The expected return could be very easily read from the Y axis. The securities A and B
are aggressive securities, because their beta values are greater than one. When beta values
are less than one, they are known as defensive securities. In our example, security C has the
beta value less than one.

Evaluation of Securities

Relative attractiveness of the security can be found out with the help of security
market line. Stocks with high risk factor are expected to yield more return and vice-versa.
But the investor would be interested in knowing whether the security is offering return
more or less proportional to its risk.

Evaluation of Securities with SML

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 The figure provides an explanation for the evaluation. There are nine points in the
diagram. A, B and C lie on the security market line, R, S and T above the SML and U, V and
W below the SML. ARU have the same beta level of, 9. Likewise beta values of SBV = 1.00
and TCW = 1.10. The stocks above the SML yield higher returns for the same level of risk.
They are underpriced compared to their beta value. With the simple rate of return formula,
we can prove that they are undervalued.

Pi is the present price P0 - the purchase price and Div - Dividend. When the purchase
price is low i.e. when the denominator value is low, the expected return could be high.
Applying the same principle the stocks U, V and W can be classified as overvalued securities
and are expected to yield lower returns than stocks of comparable risk. The denominator
value may be high i.e. the purchase price may be high. The prices of these scripts may fall
and lower the denominator. There by, they may increase the returns on securities.

The securities A, B and C are on the line. Therefore considered to be appropriately

valued. They offer returns in proportion to their risk. They have average 4oclc performance,
since they are neither undervalued nor overvalued.

Market Imperfection and SML

Information regarding the share price an4 market condition may not be immediately
available to all investors. Imperfect information may affect the valuation of securities. In
a market with perfect information, all securities should lie on SML. Market imperfections
would lead to a band of SML rather than a single line. Market imperfections affect the width
of the SML to a band. If imperfections are more, the width also would be larger. SML in
imperfect market is given in figure.

SML in Imperfect Market

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Empirical Tests of the CAPM

In the CAPM, beta is used to estimate le systematic of the security and reflects
the future volatility of the stock in relation to the market. Future volatility of the stock is
estimated only through historical data. Historical data are used to plot the regression line or
the characteristic line and calculate beta. If historical betas are stable over a period of time,
they would be good proxy for their ex-ante or expected risk.

Robert A. Levy, Marshall B. Blume and others have studied the question of beta
stability in depth. I calculated betas for both Individual securities and portfolios. His study
results have provided the following conclusions

(1) The betas of individual stocks are unstable; hence the past betas for the individual
securities are not good estimators of future risk.

(2) The betas of portfolios of ten or more randomly selected stocks are reasonably
stable, hence the portfolio betas are good estimators of future portfolio volatility.
This is because of the errors in the estimates of individual securities’ betas tend to
offset one another in a portfolio.

Various researchers have attempted to find out the validity of the model by calculating
beta and realized rate of return. They attempted to test (1) whether the intercept is equal to
i.e. risk free rate of interest or the interest rate offered for treasury bills (2) whether the line
is linear and pass through the beta = 1 being the required rate of return of the market. In
general, the studies have showed the following results.

(1) The studies generally showed a significant positive relationship between the
expected return and t systematic risk. But the slope of the relationship is usually
less than that of predicted by the CAPM.

(2) The risk and return relationship appears to be linear. Empirical studies give no
evidence of significant curvature in the risk/return relationship,.

(3) The attempts of the researchers to assess the relative importance of the market
and company risk have yielded definite results. The CAPM theory implies that
unsystematic risk is not relevant, but unsystematic and systematic risks are positively
related to security returns. Higher returns are needed to compensate both the risks.
Most of the observed relationship reflects statistical problems rather than the true
nature of capital market.

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 (4) According to Richard Roll, the ambiguity of the market portfolio leaves the CAPM
untestable. The practice of using indices as proxies is loaded with problems.
Different indices yield different betas for the same security.

(5) If the CAPM were completely valid, i4 should apply to all financial assets including
bonds. But, when bonds are introduced into the analysis, they do not fall on the
security market line.

Present Validity of CAPM

The CAPM is greatly appealing at an intellectual level, logical and rational. The basic
assumptions on which the model is built raise, some doubts in the minds of the investors.
Yet, investment analysts have been more creative in adapting CAPM for their uses.

(1) The CAPM focuses on the market risk, makes the investors to think about the
riskiness of the assets in general. CAPM provides basic concepts which are truly of
fundamental value.

(2) The CAPM has been useful in the selection of securities and portfolios. Securities
with higher returns are considered to be undervalued and attractive for buy. The
below normal expected return yielding securities are considered to be overvalued
and Suitable for sale.

(3) In the CAPM, it has been assumed that investors consider only the market risk.
Given the estimate of the risk free rate, the beta of the firm, stock and the required
market rate of return, one can find out the expected returns for a firm’s security.
This expected return can be used as an estimate of the cost of retained earnings.

(4) Even though CAPM has been regarded as a useful tool to financial analysts, it has its
own critics too. They point out, when the model is ex-ante, the inputs also should
be ex-ante, i.e. based on the expectations of the future. Empirical tests and analyses
have used ex-post i.e. past data only.

(5) The historical data regarding the market return, risk free rate of return and betas
vary differently for different periods. The various methods used to estimate these
inputs also affect the beta value. Since the inputs cannot be estimated precisely, the
expected return found out through the CAPM model is also subjected to criticism 4

****

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 Lesson 5.2 - Arbitrage Pricing Theory

Arbitrage pricing theory is one of the tools used by the investors and portfolio
managers. The capital asset pricing theory explains the return of the securities on the
basis of their respective betas. According to the previous models, the investor chooses the
investment on the basis of expected return and variance. The alternative model developed
in asset pricing by Stephen Ross is known as Arbitrage Pricing Theory. The APT theory
explains the nature of equilibrium in the asset pricing in a less complicated manner with
fewer assumptions compared to CAPM.

Arbitrage

Arbitrage is a process of earning profit by taking advantage of differential pricing for

the same asset. The process generates riskless profit. In the security market, it is of selling
security at a high price and the simultaneous purchase of the same security at a relatively
lower price.

Since the profit earned through arbitrage is riskless, the investors have the incentive
to undertake this whenever an opportunity arises. In general, some investors indulge
more in this type of activities than others. However, the buying and selling activities of
the arbitrageur reduce and eliminate the profit margin, bringing the market price to the
equilibrium level.

The Assumptions

1. The investors have homogenous expectations.

2. The investors are risk averse and utility maximisers.
3. Perfect competition prevails in the market and there is no transaction cost.

The APT theory does not assume (1) single period investment horizon, (2) no taxes
(3) investors can borrow and lend at risk free rate of interest and (4) the selection of the
portfolio is based on the mean and variance analysis. These assumptions are present in the
CAPM theory.

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Arbitrage Portfolio

According to the APT theory an investor tries to find out the possibility to increase
returns from his portfolio without increasing the funds in the portfolio. He also likes to keep
the risk at the same level. For example, the investor holds A, B and C securities and he wants
to change the proportion of the securities without any additional financial commitment.
Now the change in proportion of securities can be denoted by X A, XB, and XC. The increase
in the investment in security A could be carried out only if he reduces the proportion of
investment either in B or C because it has already stated that the investor tries to earn
more income without increasing his financial commitment. Thus, the changes in different
securities will add up to zero. This is the basic requirement of an arbitrage portfolio. If X
indicates the change in proportion,

ΔX A + Δ XB + ΔXC = 0

The factor sensitivity indicates the responsiveness of a security’s return to a

particular factor. The sensitiveness of the securities to any factor is the weighted average
of the sensitivities of the securities, weights being the changes made in the proportion. For
example bA, bB and b are the sensitivities, in an arbitrage portfolio the sensitivities become
zero.

hAΔX A +bBΔXB +bcΔXc = 0

The investor holds the A, B and C stocks with the following returns and sensitivity
to changes in the industrial production. The total amount invested is ` 1,50,000.

I R b Original weights
Stock A 20% .45 .33
Stock B 15% 1.35 .33
Stock C 12% .55 .34

Now the proportions are changed.

The changes are

ΔX A = .02
ΔXB = .025
ΔXc = -.225

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For an arbitrage portfolio

ΔX A + ΔXB + ΔXc = 0
.2 + .025 -.225 =0

The sensitivities also become zero

ΔX AbA+ ΔXBbB + ΔXcbc =0

.2 x .45 + .025 x 1.35 -.225 x .55 = 0

In an arbitrage portfolio, the expected return should be greater than zero.

ΔX ARA+ ΔXBRB + ΔXcRc > 0

.2 x 20 + .025 x 15 -.225 x 12
4.375—2.7 > 0
i.e. 1675%

The investor would increase his investment in stock A and B by selling C. The new
compositions of weights are

X A = 0.53
XB = 0.355
Xc = 0.115

The portfolio allocation on stocks A, B and C is as follows

= 1, 50,000 X .53 + 1, 50,000 X .355 + 1, 50,000 x .115

= ` 79, 500 +53250 +17250

The sensitivity of the new portfolio will be

= .45x.53+ l.35x.355+.55x.115
= .239 + .479 + .063 =.781

This is same as the old portfolio sensitivity

i.e. .45x.33+ 1.35x.33+ .55x.34= .781

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The return of the new portfolio is higher than the old portfolio.
Old portfolio return

= 20x.33+ 15x.33+ 12x.34

= 6.6 + 4.95 + 4,08
= 15.63%

The new portfolio return

= 20x.53+ 15x.355+ 12x.115

= 10.6 + 5.325 + 1.38
= 17.305%

This is equivalent to the old portfolio return plus the return that occurred due to the
change in portfolio

= 15.63% +1.675% = 17.305%

The variance of the new portfolio’s change is only due to the changes in its non-
factor risk. Hence, the change in the risk factor is negligible. From the analysis it can be
concluded that

1. The return in the arbitrage portfolio is higher than the old portfolio.
2. The arbitrage and old portfolio sensitivity remains the same.
3. The non-factor risk is small enough to be ignored in an arbitrage portfolio.

Effect on Price

To buy stock A and B the investor has to sell stock C. The buying pressure on stock A
and B would lead to increase in their prices. Conversely selling of stock C will result in fall
in the price of the stock C. With the low price there would be rise in the expected return of
stock C. For example, if the stock “C” at price ` 100 per share have earned 12 percent return,
at ` 80 per share the return would be 12/80 x 100=15%.

At the same time, return rates would be declining in stock A and B with the rise
in price. This buying and selling activity will continue until all arbitrage possibilities
are eliminated. At this juncture, there exists an approximate linear relationship between
expected returns and sensitivities.

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The APT Model

According to Stephen Ross, returns of the securities are influenced by a number

of macro economic factors. The macro economic factors are growth rate of industrial
production, rate of inflation, spread between long term and short term interest rates and
spread between low-grade and high grade bonds. The arbitrage theory is represented by the
equation:

Ri = λ0 + λ1bi1 + λ2bi2 + ……. + λjbij

Ri = average expected return
λI = sensitivity of return to bil
bil = the beta co-efficient relevant to the particular factor.

The equation is derived from the model

Ri = α1 + bil I1 + b12I2 ….. + bij Ij + ei

Let us take the two factor model

Ri = λ0 + λ1b12 + λ2b12 + b2

If the portfolio is a well diversified one, unsystematic risk tends to be zero and
systematic risk is represented by bi1 and bi2 in the equation.

Let us assume the existence of three well diversified portfolios as shown in the table.

Portfolio Expected return b12 bi2

A 12.0 1 0.5
B 13.4 3 0.2
C 12 3 -0.5

The equation Ri = λ0 + λ1bi1 + λ2bi2 + b2 can be determined with the help of the above
mentioned details. By solving the following equations

12 = λ0 + 1λ1 + 0.5λ2
13.4 = λ0 + 3λ1 + 0.2λ2
12 = λ0 + 3λ1 - 0.5λ2

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We can get

Ri = 10 + 1bil + 2bi2

The expected return is

Rp = ∑  i=1N XiRi

The risk is indicated by the sensitivities of the factors

bp1 = ∑ i=1N Xibi1;bp2 =   

∑ i=1N Xibi2

All the portfolios constructed from portfolios A, B and C lie on the plane described
A, B and C. Assume there exists a portfolio D with an expected return 14%, bi1 2.3 and bi2 =
.066. This portfolio can be compared with the portfolio E having equal portion of A, B and
C portfolios. Every portfolio would have a share of 33%. The portfolio b are

bp1 =1/3 x 1+ 1/3 x 3 + 1/3 x 3 = 2.33

bp2 =0.5 x l/3 + 0.2 x 1/3 + (-0.5 x 113)=0.066

The risk for portfolio E is identical to the risk on portfolio D. The expected return
for portfolio B is

1/3(12) + 1/3(13.4) + 1/3(12)

=12.46

Since the portfolio B lies on the plane described above, the return could be obtained
from the equation of the plane.

R = 10 + 1(2.33)+2(.066)
= 12.46

The portfolio D and B have the same risk but different returns. In this juncture,
the arbitrageur enters in and buy portfolio D t selling portfolio B short. Thus buying of
portfolio D through the funds generated from selling B would provide riskless profit with
no investment and no risk. Let us assume that the investor sells Rsr1000 with of portfolio E
and buys Rs1000 worth of portfolio D. The cash flow is as shown in the following table.

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 Initial cash flow End of period bi1 bi2
Portfolio D + 1140.0 + 2.33 + .06
` 1000
Portfolio E - 1124.6 - 2.33 - .06
` 1000
Arbitrage
0
Portfolio 15.4 -0 0

The arbitrage portfolio involves zero investment, has no systematic risk (bil and bi2)
and earns ` 15.4. Arbitrage would continue until portfolio D lies on the same plane.

Arbitrage Pricing Equation

In a single factor model, the linear relationship between the return and sensitivity b
can be given in the following form.

R i = λ 0 + λ ibi
Ri = return from stock A
λ0 = riskless rate of return
bi = the sensitivity related to the factor
λi = slope of the arbitrage pricing line

The above model is known as single factor model since only one factor is considered.
Here, the industrial production alone is considered. The APT one factor model is given in
figure.

The risk is measured along the horizontal axis and the return on the vertical axis.
The A, B and C stocks are considered to be in the same risk class The arbitrage pricing line

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intersects the Y axis on which represents riskless rate of interest i e the interest offered for
the treasury bills Here, the investments involve zero risk and it is appealing to the investors
who are highly risk averse stands for the slope of arbitrage pricing line It indicates market
price of risk and measures the risk-return trade off in the security markets. The is the
sensitivity coefficient or factor beta that shows the sensitivity of the asset or stock A to the
respective risk factor.

The Constants of the APT Equation

The existence of the risk free asset yields a risk free rate of return that is a constant.
The asset does not have sensitivity to the factor for example, the industrial production.

If bi = 0
R i = λ 0 + λ iO
Ri = λ0

In other words, λ0 is equal to the risk free rate of return. If the single factor portfolio’s
sensitivity is equal to one i.e. b1 = 1 then

R i = λ 0 + λ i1

This can be rewritten as

Ri = λ0 + λi
Ri - λ0 = λi

Thus λ1 is the expected excess return over the risk free rate of return for a portfolio
with unit sensitivity to the factor. The excess return is known as risk premium.

Factors Affecting the Return

The specification of the factors is carried out by many financial analysts. Chen, Roll
and Ross have taken four macro economic variables and tested them. According to them
the factors are inflation, the term structure of interest rates, risk premium and industrial
production. Inflation affects the discount rate or the required rate of return and the size
of the future cash flows. The short term inflation is measured by monthly percentage
changes in the consumer price index. The interest rates on long term bonds and short term
bonds differ. This difference affects the value of payments in future relative to short term

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payments. The difference between the return on the high grade bonds and low grade (more
risky) bonds indicates the market’s reaction to risk. The industrial production represents
the business cycle. Changes in the industrial production have an impact on the expectations
and opportunities of the investor. The real value of the cash flow is also affected by it.

Burmeister and McElroy have estimated the sensitivities with some other factors.
They are given below

➢➢ 
Default risk
➢➢ 
Time premium
➢➢ 
Deflation
➢➢ 
Change in expected sales
➢➢ 
The market returns not due to the first four variables.

The default risk is measured by the difference between the return on long term
government bonds and the return on long terms bonds issued by corporate plus one-half
of one per cent. Lime premium is measured by the return on long term government bonds
minus one month Treasury bill rate one month ahead.

Deflation is measured by expected inflation at the beginning of the month minus

actual inflation during the month. According to then, the first four factors accounted 25%
of the variation in the Standard and 1or Composite Index and all the four co-efficient were
significant.

Salomon Brothers identified five factors in their fundamental factor model. Inflation
is the only common factor identified by others. The other factors are given below

➢➢ 
Growth rate in gross national product
➢➢ 
Rate of interest
➢➢ 
Rate of change in oil prices
➢➢ 
Rate of change in defence spending

All the three sets of factors have some common characteristics. They all affect the
macro economic activities. Inflation and interest rate are identified as common factors.
Thus, the stock price is related to aggregate economic activity and the discount rate of
future cash flow

250
APT and CAPM

The simplest form of APT model is consistent with the simple form of the CAPM
model. When only one factor is taken into consideration, the APT can be stated as:

R i = λ 0 + bi λ i

It is similar to the capital market line equation

R = Rf + ß (Rm —Rf )

Which is similar to the CAPM model?

APT is more general and less restrictive than CAPM. In APT, the investor has no
need to bold the market portfolio because it does not make use of the market portfolio
concept. The portfolios are constructed on the basis of the factors to eliminate arbitrage
profits. APT is based on the law of one price to hold for all possible portfolio combinations.

The APT model takes into account of the impact of numerous factors on the security.
The macro economic factors are taken into consideration and it is closer to reality than
CAPM.

The market portfolio is well defined conceptually. In APT model, factors are not well
specified. Hence the investor finds it difficult to establish equilibrium relationship. The well
defined market portfolio is a significant advantage of the CAPM leading to the wide usage
of the model in the stock market.

The factors that have impact on one group of securities may not affect another group
of securities. There is a lack of consistency in the measurements of the APT model.

Further, the influences of the factors are not independent of each other. It may be
difficult to identify the influence that corresponds exactly to each factor. Apart from this,
not all variables that exert influence on a factor are measurable.

****

251
 Lesson 5.3 - Portfolio Evaluation

Portfolio manager evaluates his portfolio performance and identifies the sources
of strength and weakness. The evaluation of the portfolio provides a feed back about the
performance to evolve better management strategy. Even though evaluation of portfolio
performance is considered to be the last stage of investment process, it is a continuous
process. The managed portfolios are commonly known as mutual funds. Various managed
portfolios are prevalent in the capital market. Their relative merits of return and risk criteria
have to be evaluated.

Mutual Fund

Mutual fund is an investment vehicle that pools together funds from investors to
purchase stocks, bonds or other securities. An investor can participate in the mutual fund
by buying the units of the fund. Each unit is backed by a diversified pool of assets, where the
funds have been invested. A closed-end fund has a fixed number of units outstanding. It is
open for a specific period. During that period investors can buy it. The initial offer period
is terminated at the end of the pre-determined period. The closed-end schemes are listed
in the stock exchanges. The investor can trade the units in the stock markets just like other
securities. The prices may be either quoted at a premium or discount.

In the open-end schemes, units are sold and bought continuously. The investors can
directly approach the fund managers to buy or sell the units. The price of the unit is based
on the net asset value of the particular scheme. The net asset value of the fund is the value
of the underlying securities of the scheme. The net asset value is calculated on a daily or
weekly basis.

The gain or loss made by the mutual fund is passed on to the investors after deducting
the administrative expenses and investment management fees, The gains are distributed to
the unit holder in the form of dividend or reinvested by the fund to generate further gains.

The mutual fund may be with or without a load factor. A commission or charge paid
by the investors while purchasing or selling the mutual fund is known as load factor. Front-
end load is charged when units are sold by the funds and back-end load is charged when
the units are repurchased by the funds. The front-end load factor reduces the units when

252
the investor buys it and the back-end load reduces the investor’s proceeds when he sells
the units. Generally, the load factor ranges between 1 and 6 per cent of the net asset value.
Sometimes, the fund may not charge both the loads.

Advantages of Mutual Funds

The Association of Mutual Funds in India (AMFI), a non- profit organization serving
the cause of mutual funds, has listed the following advantages to the investors in mutual
funds.

1. Professional Management

Experienced fund managers supported by a research team, select appropriate

securities to the fund. The forecasting of the market is done effectively.

2. Diversification

Mutual funds invest in a diverse range of securities and over many industries. Hence,
all the eggs are not placed in one basket. Normally an investor has to have large sum of
money to achieve this objective, if he invests directly in the stock market. Through mutual
funds, he can achieve diversification of portfolio at a fraction of the cost.

3. Convenient Administration

For the investors there is reduction in paper work and saving in time. It is also
very convenient. Mutual funds help in overcoming the problems relating to bad deliveries,
delayed payments and the like.

4. Return Potential

Medium and the long term mutual funds have the potential to provide high returns.

5. Low Costs

The funds handle the investments of a large number of people, they are in a position
to pass on relatively low brokerage and other costs. This is because the funds can take
advantage of the economies of scale.

253
6. Liquidity

Mutual funds’ provide liquidity in t ways. In open-end schemes, the investor can get back
his money at any time by selling back the units to the fund at NAV related prices. In closed-
end fund, he has the option to sell the units through the stock exchange.

7. Transparency

Mutual funds provide information on each scheme about the specific investments
made there under and so on.

8. Flexibility

Currently most funds have regular investment plans, regular withdrawal plans and
dividend reinvestment schemes. A great deal of flexibility is assured in the process.

9. Choice of Scheme

Mutual funds offer a variety of schemes to suit varying needs of the investors.

10. Well — Regulated

The funds are registered with the Securities and Exchange Board of India and their
operations are continuously monitored.

Sharpe’s Performance Index

Sharpe’s performance index gives a single value to be used for the performance
ranking of various funds or portfolios. Sharpe index measures the risk premium of the
portfolio relative to the total amount of risk in the portfolio. This risk premium is the
difference between the portfolio’s average rate of return and the riskless rate of return. The
standard deviation of the portfolio indicates the risk. The index assigns the highest values
to assets that have best risk-adjusted average rate of return

Rp - Rf
St =
σp

Portfolio average return-Risk free rate of interest

Sharp Index =
   Standard deviation of the portfolio return

254
The details of two hypothetical funds A and B are given below

Risk and Return for Funds A and B

Average Annual Riskless Rate Standard
Fund St
Return of Interest Deviation

A 0.0879 0.05 0.0829 0.0879 – 0.5

.829
= 0.457
B 0.1347 0.05 0.1982 0.1347 – 0.5
0.1982
= 0.427

The larger the S. better the fund has performed. Thus, A ranked as better fund
because its index .457> .427 even though the portfolio B had a higher return of 13.47 per
cent. It is shown in Figure. The reason is that the fund ‘B’s managers took such a great risk to
earn the higher returns and its risk adjusted return was not the most desirable. Sharpe index
can be used to rank the desirability of funds or portfolios, but not the individual assets. The
individual asset contains its diversifiable risk.

Treynor’s Performance Index

To understand the Treynor index, an investor should know the concept of

characteristic line. The relationship between a given market return and the fund’s return
is given by the characteristic line. The fund’s performance is measured in relation to the

255
market performance. The ideal fund’s return rises at a faster rate than the general market
performance when the market is moving upwards and its rate of return declines slowly than
the market return, in the decline. The ideal fund may place its fund in the treasury bills or
short sell the stock during the decline and earn positive return. The relationship between
the ideal fund’s rate of return and the market’s rate of return is given by the figure

The market return is given on the horizontal axis and the fund’s rate of return on the
vertical axis. When the market rate of return increases, the fund’s rate of return increases
more than proportional and vice-versa. In the figure the fund’s rate of return is 20 per cent
when the market’s rate of return is 10 per cent, and when the market return is —10, the
fund’s return is 10 per cent. The relationship between the market return and fund’s return
is assumed to be linear.

This linear relationship is shown by the characteristic line. Each fund establishes a
performance relationship with the market. The characteristic line can be drawn by plotting
the fund’s rate of return for a given period against the market’s return for the same period.
The slope of the line reflects the volatility of the fund’s return.

A steep slope would indicate that the fund is very sensitive to the market performance.
If the fund is not so sensitive then the slope would be a slope of less inclination.

All the funds have the same slope indicating same level of risk. The investor would
prefer A fund, because it offers superior return than funds C and B for the same level of risk
exposure. This is shown in (Figure)

With the help of the characteristic line Treynor measures the performance of the
fund. The slope of the line is estimated by

256
 Rp = a + βRm + ep
Rp = Portfolio return
Rm = The market return or index return
ep = The error term of the residual
a, β = Co-efficients to be estimate

Beta co-efficient is treated as a measure of undiversifiable systematic risk

Portfolio average return-Risk free rate of interest

Tn =
   Standard deviation of the portfolio return

Tn = Rp - Rf
βp

Treynor’s risk premium of the portfolio is the difference between the average return
and the riskless rate of return. The risk premium depends on the systematic risk assumed in
a portfolio. Let us analyse to hypothetical funds.

Fund Average Return Beta Risk Premium Rf Tn

A 0.0879 0.499 .0379 .05 0.0879– 0.5
.499
= 0.076
B 0.1347 1.2493 0.0847 .05 0.1347–0.5
1.2493
= 0.0678

257
Jensen’s Performance Index

The absolute risk adjusted return measure was developed by Michael Jensen and
commonly known as Jensen’s measure. It is mentioned as a measure of absolute performance
because a definite standard is set and against that the performance is measured. The standard
is based on the manager’s predictive ability. Successful prediction of security price would
enable the manger to earn higher returns than the ordinary investor expects to earn in a
given level of risk.

The basic model of Jensen is given below

Rp = α + ß (Rm – Rf )
Rp   = average return of portfolio
Rf = riskless rate of interest
α = the intercept
ß = a measure of systematic risk
Rm = average market return

The return of the portfolio varies in the same proportion of 13 to the difference
between the market return and riskless rate of interest. Beta is assumed to reflect the
systematic risk. The fund’s portfolio beta would be equal to one if it takes a portfolio of
all market securities. The 13 would be greater than one if the fund’s portfolio consists of
securities that are riskier than a portfolio of all market securities. The figure shows the
relationship between beta and fund’s return.

258
 Any professional manager would be expected to earn average portfolio return of R =
R1 + 1 (Rm_ Rf). If his predictive ability is superior, he should earn more than other funds
at each level of risk. If the fund manager has consistently performed better than average Rp,
there would be some constant factor that would make the actual return higher than average
R. The constant may be that represents the forecasting ability of the manager. Then the
equation becomes

Rp – Rf = αp + ß (Rm – Rf )
Or
Rp = αp + Rf + ß (Rm – Rf )

By estimating this equation with regression technique, Jensen claimed a the

constant, reflected the professional management’s ability to forecast the price movements.
A comparative analysis of three hypothetical funds A, B and C are given in the figure.

Jensen’s Measure of Management Ability

259
 Fund A’s αp is equal to the risk free rate of return. If no risk is undertaken, the
portfolio is expected to earn at least Rf. It is hypothesized that it takes no particular
professional managerial ability to increase the return Rp by increasing (Rm – Rf). In the
fund C, the manager’s predictive ability has made him earn more than Rf. The fund manager
‘would be consistently performing better than the fund A. At the same time if the profession
management has not improved, it ‘would result in a negative a. This is shown by the line B.
Here the is even below the riskless rate of interest. Jensen in his study of 115 funds, he found
out that only 39 funds possessed positive a and employing professional management has
improved the expected return. On an average, fund’s performance is worse than expected,
without professional management and if any investor is to purchase fund’s shares, he must
be very selective in his evaluation of management. Thus, Jensen’s evaluation of portfolio
performance involves two steps.

1. Using the equation the expected return should be calculated.

2. With the help of 3, Rm and R,, he has to compare the actual return with the expected
return. If the actual return is greater than the expected return, then the portfolio
is considered to be functioning in a better manner. The following table gives the
portfolio return and the market return. Rank the performance.

Portfolio Return and Market Return

Portfolio Rp β Rf
A 15 1.2 5%
B 12 0.8 5%
C 15 1.5 5%
Market Index 12 1.0 5%

The return can be calculated with the given information using the formula:

Rp = Rf + ß (Rm – Rf )
Portfolio A = 5 + 1.2 (12-5) = 13.4
Portfolio B = 5 + 0.8 (12-5) = 10.6
Portfolio C = 5 + 1.5 (12-5) = 15.5

The difference between the actual and expected return is compared.

Portfolio A = 15—13.4= 1.6

Portfolio B = 12—10.6 = 1.4
Portfolio C =15—15.5 = -0.5:

260
 Among the risk adjusted performance and of the three portfolios, A is the best, B -
the second best and the last is the C portfolio.

Example

Mr. X has owned units from three different mutual funds namely R, S, and T. The following
particulars are available to him. He wants to dispose any one of the mutual fund for his
personal expenditure. Which fund should he dispose?

Funds Excess Average Return Beta

R 7.7 1.02
S 11.3 0.99
T 11.6 1.07
Market 7.8 1.00

Ans: The performance can be evaluated by finding out the differential return. R - R = a +
(R - R? (or)

Rp – Rf = αp + ß (Rm – Rf ) Or
Rp = αp + Rf + ß (Rm – Rf )

Portfolio R
αp = (Rp - Rf ) - ßp (Rm – Rf )
  = 7.7— 1.02 x7.8 = -.256.

Portfolio S
αp = 11.3 - .99 x 7.8
  = 3.578

Portfolio C
αp = 11.6—1.07(7.8)
  = 3.254

Since the Portfolio R has a negative alpha value Mr. X can sell th portfolio R and
keep the other

For ranking purpose, Jensen measure should be properly adjusted. Each asset’s alpha
value should be divided by its beta co-efficient.

261
****

262
 Lesson 5.4 - Portfolio Revision

The care taken in the construction of the portfolio should be extended to the review
and revision of the portfolio. Fluctuations that occur in the equity prices cause substantial
gain or loss to the investors. The investor should have competence and skill in the revision
of the portfolio. Normally the average investor dislikes to sell in the bull market with the
anticipation of further rise. Likewise, he is reluctant to buy in the bear market with the
anticipation of further fall.

The portfolio management process needs frequent changes in the composition of

stocks and bonds. In securities, the type of securities to be held should be revised according
to the portfolio policy. If the policy of investor shifts from earnings to capital appreciation,
the stocks should be revised accordingly. An investor can sell his shares if the price of
shares reaches the historic high prices. Likewise, if the security does not fulfill the investor’s
expectation regarding return and growth, it is better to get rid of it. The investor should also
consider the factors like risk, quality and tax concessions. If another stock offers a competitive
edge over the present stock, investment should be shifted to the other stock. Many investors
find themselves inadequate in their ability to trade and earn profit. Mechanical methods are
adopted to earn better profit through proper timing. Such types of mechanical methods are
Formula Plans and Swaps.

Passive Management

Passive management is a process of holding a well diversified portfolio for a long

term with the buy and hold approach. Passive management refers to the investor’s attempt
to construct a portfolio that resembles the overall market returns. The simplest form of
passive management is holding the Index fund that is designed to replicate a good and well
defined index of the common stock such as BSE-Sensex or NSE-Nifty. The fund manager
buys every stock in the index in exact proportion of the stock in that index. If Reliance
Industry’s stock constitutes 5% of the index, the fund also invests 5% of its money in Reliance
Industry stock.

The problem in the index fund is the transaction cost. If it is NSE-Nifty, the manager
has to buy all the 50 stocks in market proportion and cannot leave the stocks with smallest
weights to save the transaction costs. Further, the reinvestment of the dividends also poses

263
a problem. Here, the alternative is to keep the cash in hand or to invest the money in stocks
incurring transaction cost. Keeping away the stock of smallest weights and the money in
hand fail to replicate the index fund in the proper manner. The commonly used approaches
in constructing an index fund are as follows:

1. Keeping each stock in proportion to its representation in the index

2. Holding a specified number of stocks for example 20, which historically track the
index in the best manner.

3. Holding a smaller set of stocks to match the index in a pre-specified set of

characteristics. This may be in terms of sector, industry and the market capitalisation.

Active Management

Active Management is holding securities based on the forecast about the future.
The portfolio managers who pursue active strategy with respect to market components are
called ‘market timers’. The portfolio managers vary their cash position or beta of the equity
portion of the portfolio based on the market forecast. The managers may indulge in ‘group
rotation’s. Here, the group rotation means changing the investment in different industries’
stocks depending on the assessed expectations regarding their future performance.

Stocks that seem to be best bets or attractive are given more weights in the portfolio
than their weights in the index. For example, Information Technology or Fast Moving
Consumer Goods industry stocks may be given more weights than their respective weights
in the NSE-50. At the same time, stocks that are considered to be less attractive are given
lower weights compared to their weights in the index.

Here, the portfolio manager may either remain passive with respect to market and
group components but active in the stock selection process or he may be active in the
market, group and stock selection process.

The Formula Plans

The formula plans provide the basic rules and regulations for the purchase and sale
of securities. The amount to be spent on the different types of securities is fixed. The amount
may be fixed either in constant or variable ratio. This depends on the investor’s attitude
towards risk and return. The commonly used formula plans are rupee cost averaging,
constant rupee value, the constant ratio and the variable ratio plans. The formula plans help
to divide the investible fund between the aggressive and conservative portfolios.

264
 The aggressive portfolio consists more of common stocks which yield high return
with high risk. The aggressive portfolio’s return is volatile because the share prices generally
fluctuate. The conservative portfolio consists of more bonds that have fixed rate of returns.
It is called conservative portfolio because the return is certain and the risk is less. The
conservative portfolio serves as a cushion for the volatility of the aggressive portfolio. The
capital appreciation in the conservative portfolio is rather slow and the fall in price of the
bond or debenture is also alike.

Assumptions of the Formula Plan

1. The first assumption is that certain percentage of the investor’s fund is allocated to
fixed income securities and common stocks. The proportion of money invested in
each component depends on the prevailing market condition. If the stock market is
in the boom condition lesser funds are allotted to stocks. Perhaps it may be a ratio of
80 per cent to bonds and 20 per cent to stocks in the portfolio. If the market is low,
the proportion may reverse. In a balanced fund, 50 per cent of the fund is invested in
stocks and 50 per cent in bonds.

2. The second assumption is that if the market moves higher, the proportion of stocks in
the portfolio may either decline or remain constant. The portfolio is more aggressive
in the low market and defensive when the market is on the rise.

3. The third assumption is that the stocks are bought and sold whenever there is a
significant change in the price. The changes in the level of market could be measured
with the help of indices like BSE-Sensitive Index and NSE-Nifty.

4. The fourth assumption requires that the investor should strictly follow the formula
plan once lie chooses it. He should not abandon the plan but continue to act on the
plan.

5. The investors should select good stocks that move along with the market. They
should reflect the risk and return features of the market. The stock price movement
should be closely correlated with the market movement and the beta value should be
around 1.0. The stocks of the fundamentally strong companies have to be included
in the portfolio.

Advantages of the Formula Plan

➢➢ 
Basic rules and regulations for the purchase and sale of securities are provided.
➢➢ 
The rules and regulations are rigid and help to overcome human emotion.
➢➢ 
The investor can earn higher profits by adopting the plans.

265
 ➢➢ 
A course of action is formulated according to the investor’s objectives.
➢➢ 
It controls the buying and selling of securities by the investor.
➢➢ 
It is useful for taking decisions on the timing of investments.

Disadvantages

➢➢ 
The formula plan does not help the selection of the security. The selection of the
security has to be done either on the basis of the fundamental or technical analysis.

➢➢ 
It is strict and not flexible with the inherent problem of adjustment.

➢➢ 
The formula plan should be applied for long periods, otherwise the transaction cost
may be high.

➢➢ 
Even if the investor adopts the formula plan, he needs forecasting. Market forecasting
helps him to identify the best stocks.

Rupee Cost Averaging

The simplest and most effective formula plan is rupee cost averaging. First, stocks
with good fundamentals and long term growth prospects should be selected. Such stocks’
prices tend to be volatile in the market and provide maximum benefit from rupee cost
averaging. Secondly, the investor should make a regular commitment of buying shares at
regular intervals. Once he makes a commitment, he should purchase the shares regardless of
the stock’s price, the company’s short term performance and the economic factors affecting
the stock market.

In the rupee cost averaging plan, the investor buys varying number of shares at
various points of the stock market cycle. In a way, it can be called time diversification. Let us
assume that an investor decides to buy Rs11000 worth of particular shares for four quarters
in one particular year, ignoring the transaction costs. The details are given in table

Rupee Cost Averaging (in ` )

Market Unrealised Average Average
Market Shares Cumulative
Quarter value Profit Cost per Market Price
Price Purchased Investment
(in `) or Loss share per share
1 100 10 1,000 1,000 0 100 100
2 90 11 1,990 1,890 (100) 94.76 95
3 100 10 2,990 3,100 110 96.45 96.67
4 110 9 3,980 4,400 420 99.50 100

266
 In the above example, the stock price fell in the second quarter but recovered in the
third quarter. The investor was able to buy more stocks in the second quarter than in the
first quarter. The benefits of this policy can be viewed by comparing the last two columns.
In the second quarter, the average cost per share is lower than the average market price per
share. This is the benefit derived from rupee cost averaging.

The rupee cost averaging for the Hero Honda stock is given in table. The process of
investment is assumed to commence in January 1996 and end in 1998, covering 12 quarters.

Advantages

The advantages of the rupee cost averaging plan are

1. Reduces the average cost per share and improves the possibility of gain over a long
period.
2. Takes away the pressure of timing the stock purchase from investors
3. Makes the investors to plan the investment programme thoroughly on the commitment
of funds that has to be done periodically
4. Applicable to bothfalling and rising market, although it works best if the stocks are
acquired in a declini1ig market.

In a nut shell, the investor must decide in advance the sum and periodic intervals at
which he has to invest. Once it is decided, the implementation is mechanical.

Limitations

1. Extra transaction costs are involved with small and frequent purchase of shares
2. The plan does not indicate when to sell. It is strictly a strategy for buying
3. It does not eliminate the necessity for selecting the individual stocks that are to be
purchased
4. There is no indication of the appropriate interval between purchases
5. The averaging advantage does not yield profit if the stock price is in a downward
trend
6. The plan seems to work better when stock prices have cyclical patterns.

The rupee cost averaging plan yields better results when applied to no load mutual
funds. The problems of high transaction costs and stock selection are eliminated. The broad

267
based index fund experiences profit if the once is volatile, allowing the averaging effect to
result in cost reduction. The investor has only to decide on the size of the fund and the
length of the interval between the purchases.

Total Cumulative Market Unrealised Average Average

Shares Investment
Quarters Price No. of Investment value Profits Cost Price
Bought (`)
Shares (`) (`) (`) (`) (`)
1 2 3 4 5 6 7 8 9 10
15.1.96 112.00 90 90 10080 10080 10080 112 112
15.4.96 142.50 70 160 9975 20055 22800 2745 125 127
15.7.96 162.00 62 222 10044 30099 35964 5865 136 139
15.10.96 130.00 77 299 10010 40109 38870 (1239) 134 137
15.1.97 152.00 66 365 10032 50141 55480 5339 137 140
7.4.97 156.50 64 429 10016 60157 67139 6982 140 143
15.7.97 301.75 33 462 9958 70115 139409 69294 152 165
15.10.97 381.88 26 488 9929 80044 186357 106313 164 192
15.1.98 390.75 26 514 10160 90204 200846 110642 176 214
15.4.98 606.25 16 530 9700 99904 321313 221409 189 254
15.7.98 443.50 23 553 10201 110105 245256 135151 199 271
15.10.98 571.00 17 570 9707 119812 325470 205658 210 296

Col 7 = Col 2 x Col 4

Col 8 = Col 7 x Col 6
Col 9 = Col 6 ÷ Col 4
Col 10 = I Qr Price + II Qr Price ÷ 2 and so on.

Constant Rupees Plan

Constant rupee, constant ratio and variable ratio plans are considered to be true
formula timing plans. These plans force the investor to sell when the prices rise and
purchase as prices fall. Forecasts are not required to guide buying and selling. The actions
suggested by the formula timing plan automatically help the investor to reap the benefits of
the fluctuations in the stock prices.

The essential feature of this plan is that the portfolio is divided into two parts, which
consists of aggressive and defensive or conservative portfolios. The portfolio mix facilitates
the automatic selling and buying of bonds and stocks.

268
 The plan The constant rupee plan enables the shift of investment from bonds to
stocks and vice-versa by maintaining a constant amount invested in the stock portion of the
portfolio. The constant rupee plan starts with a fixed amount of money invested in selected
stocks and bonds. When the price of the stocks increases, the investor sells sufficient amount
of stocks to return to the original amount of the investment in stocks. By keeping the value
of aggressive portfolio constant, remainder is invested in the conservative portfolio.

The investor must choose action points or revaluation points. The action points
are the times at which the investor has to readjust the values of the stocks in the portfolio.
Stocks’ values cannot be continuously the same and the investor has to be watchful of the
market price movements. Stocks’ value in the portfolio can be allowed to fluctuate to a
certain extent. Percentage change in price like 5%, 10% or 20% can be fixed by the investor.
Allowing only small percentage change would result in a lot of transaction cost and would
not be beneficial to the investor. If the action points are too large, the investor may not be
able get full benefit out of the price fluctuations. The table shows the constant rupee plan.
The transaction costs are not considered.

Constant Rupee Plan

Market Number Value of Stock Value of Defensive

Period Total (`
Price `) of Shares Portfolio (`) Portfolio (`)
1 50 200 10,000 10,000 20,000
2 44 200 8,800 10,000 18,800
3 40 200 8,000 10,000 18,000
4 40 250 10,000 8,000 18,000
Bought 50 Shares
5 44 250 11,000 8,000 19,000
6 50 250 12,500 8,000 20,500
7 50 200 10,000 10,500 20,500
Sold 50 Shares

According to the Table, the investor has ` 20,000 to invest and he divides it equally
between stocks and bonds 50:50 that is 10,000:10,000. He makes quarterly adjustment if the
stock portion falls or rises by 20%. In the third quarter, the stock prices fell by 20% initiating
the action. He shifted ` 2000 from the bonds’ portion and bought 50 shares. This lifted the
value of stock portion again to ` 10,000.

269
 In the fifth quarter, the stock price has increased from ` 40 to ` 50, a 20 per cent
increase. In this action point the investor disposes off the shares and shifts the money to
the bond portion. By this the stock amount in the portfolio has remained constant but the
total portfolio value has increased. The investor stands to gain by the total portfolio value
appreciation.

The major advantage of this plan is that purchase and sales are determined
automatically. This facilitates the investor to earn capital gain by selling the stocks when the
price increases and buying it at a relatively lower price. To make the plan operate effectively,
at the starting point, stocks should not be purchased either at high prices or at too low
prices. If the investor starts the purchase at the extreme price level, the stock fund
may be either too small or too large.

Constant Ratio Plan

Constant ratio plan attempts to maintain a constant ratio between the aggressive and
conservative portfolios. The ratio is fixed by the investor. The investor’s attitude towards
risk and return plays a major role in fixing the ratio. The conservative investor may like to
have more of bond and the aggressive investor, more of stocks. Once the r$io is fixed, it is
maintained as the market moves up and down. As usual, action points may be fixed by the
investor. It may vary from investor to investor. As in the previous example, when the stock
price moves up or down by 10 to 20 per cent action would be taken. Here, 10 per cent is
taken as action point. The table shows the constant ratio plan.

Constant Ratio Plan

Number of Value of Total Port- Ration of Stock

Market Value of
Shares in Defensive folio Value Portion to
Price Stock (`)
Stock Portion Portfolio (`) (`) Defensive Portion
50 100 5000 5000 10,000 1.00
48 100 4800 5000 9,800 0.96
45 100 4500 5000 9,500 0.90
` 248 transferred from bond portion and 5.5 shares purchased.
45 105.5 4748 4752 9,500 1.00
40.5 105.5 4273 4752 9,025 0.90
Bought 5.9 shares by transferring ` 239 from bond portion
40.5 111.4 4512 4511 9,023 1.00
44.5 111.4 4957 4511 9,468 1.10
5 shares are sold and invested in bonds to make the ratio equal 1:1

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 The advantage of constant ratio plan is the automatism with which it forces the
manager to counter adjust his portfolio cyclically. But this approach does not eliminate the
necessity of selecting individual security.

The limitation of the plan is that the money is shifted from the stock portion to bond
portion. Bond is also a capital market instrument and responds to market pressures. Bond
and share prices may both rise and fall at the same time. In the downtrend both prices may
decline and then gain.

Variable Ratio Plan

According to this plan, at varying levels of market price, the proportions of the
stocks and bonds change. Whenever the price of the stock increases, the stocks are sold and
new ratio is adopted by increasing the proportion of defensive or conservative portfolio.
To adopt this plan, the investor is required to estimate a long term trend in the price of the
stocks. Forecasting is very essential to this plan. When there is a wide fluctuation variable
ratio plan is useful. The table explains the variable ratio plan.

Variable Ratio Plan

Share Value of Total Stock as a Shares in

Value of Stock Portfolio
price Defensive Portfolio Percentage of Stock Portion
portion (`) Adjustment
(`) (`) value (`) Portfolio (`) (`)
100 10,000 10,000 20,000 50.00 - 100
90 9,000 10,000 19,000 47.37 - 100
80 8,000 10,000 18,000 44.4 - 100
Bought 58
80 12,640 5,400 18,040 70.06 158
shares
90 14,220 5,400 19,620 72.48 - 158
Sold 50
100 15,800 5,400 21,200 74.53 158
shares
100 10,800 10,800 21,600 50.00 - 108

In the above example, the portfolio is adjusted for every 20 per cent change in the
stock price. This adjustment criterion may be different for different investors depending
upon their attitude towards risk and return. The portfolio is divided into two equal portions
as in the case of other plans, with R,10,000 in each. Let us assume that there is a fall in the
price of the stock, then, the percentage of stock in the portfolio declines. As the market
price for the stock reaches a 20 per cent decline, that is to Rs,80, the adjustment action takes

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place. The purchase of 58 shares raises the stock portion to 72.48 per cent. Once again,
when there is a 20 per cent change, the adjustment action is triggered. When the prices
have increased to ` 100, the investor sells 50 shares and the stock portion in the portfolio is
reduced back to 50 per cent.

The figure explains the variable ratio plan.

The middle line is the trend line that represents the investor’s expectation about of
future course of prices. Zone 1 and 3 represent respectively of 10 and 20 per cent deviations
above the expected trend, and zones 2 and 4 represent respectively 10 and 20 per cent
deviations below the expected trend. Starting at ` 50, the portfolio’s bonds and stocks ratio
is 50:50.

At point A, the portfolio is adjusted to the next proportion, in this case 60 per cent
bonds and 40 per cent stocks. At B, again it is 50:50. Below point C there would be more
stocks than bonds. Because of the decline in stock price, more stocks are purchased. Above
the point D, it is again 50:50. The line moves closer to the trend line

Advantages

Automatically, the investor tends to correct his portfolio portions according to the
price changes. The investor is not emotionally affected by the price changes in the market.
With accurate forecast the variable ratio plan takes greater advantage of price fluctuations
than the constant ratio plan.

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Limitations

1. The investor has to construct the appropriate zones and trend for alterations of the
proportions

2. The selection of security has to be done by the investor by analysing the merits of the
stock. The plan does not help in the selection of scrips.

3. If the zones are too small frequent changes have to be done and it would limit
portfolio performance.

Revision and the Cost

With the passage of time the stocks which were attractive once may turn out to be
less attractive in terms of return. The investor’s attitude towards risk and return also may
change and the forecast regarding the market also may undergo change. In this context, the
necessary revision is thought of by the portfolio manager. In revision of traded volumes the
portfolio manager has to incur brokerage commission, price impact and bid-ask spread.
Price impact means the effects on the price of stock. In simple terms, if the size of the trade
is heavy on the buying side, the prices of the stock may increase. The bid-ask spread is the
difference between the price that the market maker is willing to buy and sell the stock.
These costs may be higher in small size stocks and the benefits of revision may be nullified
by it. Usually revision is done with the view of either increasing the expected return of the
portfolio or to reduce the risk (standard deviation) of the portfolio.

SWAPS

Swap is a contract between two parties to exchange a set of cash flows over a pre-
determined period of time. The two parties are known as counter parties. In an equity
swap one counter party, say ‘A’, agrees to pay cash based on the rate of return of an agreed
stock market index to the second counter party ‘B’. Since the payments are based on the
market index, they vary according to index movements. The second counter party B agrees
to pay the fixed amount of cash payments based on the current interest rate to the first
counterparty A. Thus, the payment depends upon the underlying security. This agreement
means that A has sold stocks and bought bonds while B has sold bonds and bought stocks.
Here, they have restricted their portfolios without the transaction costs, even though they
have to pay the swap fee to the swap bank that set up the contract between the two parties.

This can be explained with the help of an example. Consider Mr. Hope, a portfolio
manager having an expectation of upward trend in the stock market for the year and Mr.

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Despair, another portfolio manager who feels that there would be downward trend in the
market for the next year. Mr. Hope wants to sell ` 10 lakhs worth of bonds and to invest it in
the stock market, whereas Mr. Despair wants to dispose off ` 10 lakhs worth of stocks to be
invested in the bond market. Selling and buying of bonds or stocks involve transaction cost.
Hence, they approach the Swap bank. A contract has been set up between Mr. Hope and Mr.
Despair by the swap bank. The contract payments have to be made for every quarter. At the
end of each quarter, Mr. Despair has to pay Mr. Hope an amount equal to the rate of return
on the NSE-Nifty for every quarter in terms of the basic principal amount. At the same time,
Mr. Hope has to pay an amount equal to 3% of the principal. The agreed notional principal
amount is ` 10 Iakhs. The contract lasts for an year. They pay fees to the swap bank.

Let us assume that the rates of return of NSE-Nifty are 5%, - 2%, 3% and 6% for the
four quarters. Mr. Hope has to pay ` 30,000 to Mr. Despair each quarter, the payments Mr.
Despair has to make to the Mr. Hope are as follows:

Mr. Hope’s Cashflows Mr. Despair Cashflows.

Payment Payment
NSE- Net Payment Payment Net
Quarter From to
Nifty outflows From to Hope outflows
Despair Despair
Return (`) Hope (`) (`) (`)
(`) (`)
First 5% 50,000 30,000 -20,000 30,000 50,000 20,000
Second -2% -20,000 30,000 50,000 30,000 -20,000 -50,000
Third 3% 30,000 30,000 00000 30,000 30,000 00,000
Fourth 6% 60,000 30,000 -30,000 30,000 60,000 30,000

The results can be summarised

First Quarter Mr. Despair pays ` 20,000 to Mr. Hope

Second Quarter: Mr. Hope pays ` 50,000 to Mr. Despair
Third Quarter: There is no payment
Fourth Quarter: Ir. Despair pays ` 30,000 to Mr. Hope

The amount paid by Mr. Despair shows what would have transacted if Mr. Despair
had sold stocks and bought bonds. Likewise the payments made by Mr. Hope indicates what
would have happened if he had sold bonds and bought stocks. The equity swaps could be
modified based upon the index and the prevailing interest rates.

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