INVESTMENT PLANNING

INVESTMENT

PLANNING

Module 4 : Workbook

The Indian Institute of Financial Planning

The Indian Institute of Financial Planning

Contents

Copyright: IIFP

1st Edition : September 2008

The course material is exclusively designed and published for the use of the Students of the IIFP. It isnot a priced publication. No part of this publication may be reproduced or copied or sold/ distributed inany form or any means, electronic, mechanical, photocopying, and recording or stored in a data baseor retrievable system without the explicit permission of the institute.

Price: Not for Sale

Printed in INDIA

Publication: September 2008

The Indian Institute of Financial Planning

Contents

FOREWORD

Welcome to IIFP-

Power Your Growth…..

We thank you for choosing the IIFP as your preferred education provider for CFPcertification program. We are one of the leading education providers for CFPcertification program and we are basically a No Frills-Pure Education instituteimparting high quality financial planning education in India.

IIFP has been promoted by Kush Education Society which has been formed andbacked by eminent industrialists and educationists of India. Kush Education Societywas formed in the year 2001 and it also runs the prestigious Delhi Public School(DPS), Varanasi.

We are constantly engaged in research and development of new study tools whichcan help our students to crack this highly professional CFP certification program inthe first attempt itself and in light of this we feel pleasure in presenting before youfirst edition of our Work book, Module 4 (Investment Planning).

We hope that this tool will help you in your studies and we assure you that we willalways be there to help and guide you.

Wishing you Good Luck….

Faculty and Content Team, IIFP

The Indian Institute of Financial Planning

Contents

IndexPage No.

1. List of Important Formulas 1 - 10

2. Types of Risk and General Economics 11 - 16

3. Measuring Risk 17 - 38

4. Measuring Return 39 - 56

5. CAPM 57 - 62

6. Risk Adjusted Return 63 - 68

7. Fixed Income Securities 69 - 82

8. Equity Valuation 83 - 98

9. Forward and Futures 99 - 106

10. Options 107 - 132

11. Real Estate and Other Investments 133 - 138

12. Mutual Funds 139 - 142

13. Other Fixed Income Instruments and SSI 143 - 146

14. Asset Allocation Strategies 147 - 152

15. Financial Statement Analysis 153 - 172

16. Regulations 173 - 177

Chapter 1

List of Important Formulas

Chapter 1 : List of Important Formulas

1The Indian Institute of Financial Planning

Chapter 1

List of Important Formulas

Measuring Risk

1. Range = Highest Value – Lowest Value2. Variance= P

1[r

1-E(r)]2+ P

2[r

2-E(r)]2+ P

3[r

3-E(r)]2 + ... +P

n(r

n–E(r)]2

where,r

1,r

2,r

3,...,r

n= Observed Returns

E(r) = Expected returnP

1,P

2,P

3,......, P

n = Probability

3. Standard Deviation = Variance

4. Coefficient of variation = Standard Deviation

X 100

Mean

5.σ

imim

m

C ovBe ta (β ) = 2

Where,Cov

im = Co-variance between market return and security ‘i’ return

σ 2m = Variance of market return

6. Covariance of two securities

1

n

i =∑ (xi - x ) (yi - y )

n - 1

Where,x

i= Return on Security ‘i’

yi

= Return on security ‘i’x = Mean of return on Security ‘x’y = Mean of return on Security ‘y’n = Number of observations

7. Cov12

= r12

* σ 1 * σ 2

Where,Cov

12= Co – variance between return on asset ‘1’ & asset ‘2’

r12

= Coefficient of correlation between two securitiesσ 1

= Standard Deviation of asset ‘1’ returnσ 2

= Standard Deviation of asset ’2’ return

Investment Planning (Workbook)

2 The Indian Institute of Financial Planning

8. Co-efficient of correlation of security ‘i’ return with security k return

ik

i k

Cov

σ * σ

Where,

Covik = Co – variance Between asset ‘i’ & asset ‘k’σ i = Standard Deviation of asset ‘i’ return

σ m = Standard Deviation of asset ’k’ return

Return1. Cumulative Wealth Index (CWIn) = WI0 (1+R1) (1+R2) ........ (1+Rn)

CWIn = Cumulative wealth index at the end of n yearsWI0 = The begning index value which is typically one rupeeRi = Total return for year i (i = 1, .......n)

2. Arithmetic Return = R1 + R

2 + R

3 + ........... + R

n

n

= 1

n

ii

R=∑

nWhere,

R1, R

2, R

3, ..... R

4 = Returns for the different periods

n = Number of periods

1

n

ii

R=∑ = Summation of the returns for the period

3. Holding Period Return = [(Ending Price – Beginning Price + Cash Dividend) /Beginning Price] x 100.

4. Geometic Mean (G.M.) = { ( 1+ TR1) ( 1+ TR

2)….(1+ TR

n)]1/n -1} x 100

TRi

= Total return for period i, where i = (1, 2, 3...... n)n = Total holding period

5. CAGR (Compounded Annual Growth Rate)

1/nEndingValue

-1BeginningValue

x100{[ ] }

6. Real rate of Return = 1 + i

-1 x1 001 + e

{ [ ] }i = Interest Ratee = Inflation Rate

r =

Chapter 1 : List of Important Formulas

3The Indian Institute of Financial Planning

7. Post Tax Return = Return * (1 – Tax Rate)

8. Expected return : E(R) = i i1

R Pn

i=∑

Where,E(R) = Expected return from the stock

Ri = Return form the stockPi = Probability associated with the possible outcomen = Number of possible states of the world

9. Treynor Measure = (Return on portfolio - risk free return) / beta of portfolio

ip fr – r

T ß

=

Where,Ti = Treynor Indexrp = Return on Portfolio Riskrf = Risk Free Return

ß = Beta of Portfolio

10. Sharpe Measure = (Return on portfolio - risk free return)/ standard deviation of portfolio

p

S p f i

r – r

=

σ

Where,si = Sharpe Performance Indexrp = Return on Portfoliorf = Risk Free Returns p= Standard Deviation of Portfolio

11. Jensen Measure (ALPHA) = Portfolio return – [Risk free rate + (market return- risk free rate) *portfolio beta]

Jensen Measure = Rp – [Rf + (Rm – Rf)* ß p ]

Where,Rp = Portfolio ReturnRf = Risk free rateR = Market Return

ß p = Portfolio Beta

Investment Planning (Workbook)

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Portfolio Investment

1. Portfolio variance: = [Standard Deviation of Portfolio]2

2. For a two asset portfolio:Portfolio return:

( ) ( ) (1 ) ( ) ( ) ( )= + − = +p A A A B A A B BE R w E R w E R w E R w E R

Where,E(R

P) = Expected return of the portfolio

wA

= Weight of security Aw

B= Weight of security B

E(RA) = Expected return of the security A

E(RB) = Expected return of the security B

3. Variance of Portfolio Returns= W12s1

2 + W22s2

2 + 2 W 1W2 Cov12

Where co – variance is givenW1 = Weight of security 1W2 = Weight of security 2

s1 = Standard deviation of security 1s2 = Standard deviation of security 2

Cov12 = Covariance between return on security 1 & 2

4. Variance of Portfolio Returns = W12 s1

2 + W22s2

2 + 2 W1W2 r12 s1 s 2

Where correlation is givenr12 = coefficient of correlation between security 1 & 2

5. For a three asset portfolio, the variance is:

2 2 2 2 2 2A A B B C C A B AB A B A C AC A C B C BC B Cw σ +w σ +w σ +2w w r σ σ +2w w r σ σ +2w w r σ σ

Where,r

AB= Coefficient of correlation between security A and B

rBC

= Coefficient of correlation between security B and Cr

AC= Coefficient of correlation between security A and C

wA

= Weight of security Aw

B= Weight of security B

wC

= Weight of security Cσ A

= Standard deviation of security Aσ B

= Standard deviation of security Bσ C

= Standard deviation of security C