Sapm

• 1. SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT Take calculated risks. That is quite different frombeing rash.1 BY: PROF. N.N.PANDEY 10/22/12

2. SECURITY Investments in capital markets are in various financial instruments. These instruments may be of various category with different characteristics. These are called securities in the market parlance. It includes shares,bonds,debentures or any marketable securities of a like nature of any company,Govt.securities or semi-Govt.bodies.2BY: PROF. N.N.PANDEY10/22/12 3. SECURITY ANALYSIS Security analysis in both traditional sense and modern sense involves the projection of future dividend, or earnings flows, forecast of the share price in the future and estimating the intrinsic value of a security based on the forecast of earnings or dividends. In addition to above, the modern approach includes risk and return analysis for the securities. Basically securities analysis contains the analysis of: The trend and scenario of the economy. The trend and scenario of the industry to which company belongs. The strength and weakness of company itself viz. promoters and management track record, financial results, projections of expansion, diversification, tax planning etc.3BY: PROF. N.N.PANDEY10/22/12 4. PORTFOLIO A combination of such securities with different risk-return characteristics will constitute the portfolio of the investors. Thus ,a portfolio is a combination of various assets and/or instruments of investments.4 BY: PROF. N.N.PANDEY 10/22/12 5. PORTFOLIO MANAGEMENT Portfolio analysis includes portfolio construction, selection of securities, revision of portfolio, evaluation and monitoring of the performance of the portfolio. All these are part of the subject of portfolio management which is a dynamic concept ,subject to daily and hourly changes based on the information flows and a host of economic and non-economic forces operating in the country on the markets and securities.5 BY: PROF. N.N.PANDEY10/22/12 6. INVESTMENT Investment is parting with ones fund, to be used by another party, user of fund, for productive activity. It can mean giving an advance or loan or contributing to the equity(ownership capital) or debt capital of a corporate or non-corporate business entity. In other words, investing means building up to meet future consumption demand with the intention of making surpluses or profits, as they are popularly known.6BY: PROF. N.N.PANDEY10/22/12 7. INVESTMENT ACTIVITY (ACQUISITION OF ASSETS)1. FINANCIAL ASSETS2. PHYSICAL ASSETSCASH HOUSE SAVER LAND BUILDINGS FLATS BANK DEPOSITS INVESTORGOLD P.F./LIC SILVER OTHER METALSPENSION 3. MARKETABLEASSETSPOST OFFICECERTIFICATESSHARES, BONDS, CONSUMER & GOVT. SECURITIES, DURABLESDEPOSITS M.F. SCHEMES, UTINEW STOCKMARKET ISSUE7 BY: PROF. N.N.PANDEY10/22/12 8. RISK-RETURN RELATIONSHIP RISK : Risk is inherent in any investment. This risk may relate to loss or delay in repayment of the principal capital or loss or non-payment of interest or variability of returns. While some investments are almost risk less like Govt.securities or bank deposits, others are more risky. RETURN: Return differs amongst different instruments. The most important factor influencing return is risk. Normally, the higher the risk ,the higher is the return. See the figure in the next slide..8BY: PROF. N.N.PANDEY 10/22/12 9. RISK RETURN RELATIONSHIP Venture fund(highest risk) Equity shares convertible debentures / MFsNon-convertible debenturesRETURNPSU BONDS Lowest Risk (Bankdeposits)RISK9BY: PROF. N.N.PANDEY 10/22/12 10. INVESTMENT VS SPECULATION It is for a longer time horizon. It is for a short period of time. It requires higher risk. It requires moderate risk. Its objective is to get high returns Its objective is to get a moderatealong with higher risk.return with a limited risk. It considers fundamental factors and It considers inside information,evaluate the performance of the hearsays and market behavior.company regularly. Investor uses his own funds and avoid Speculator uses borrowed funds toborrowed funds. supplement his personal resources.10BY: PROF. N.N.PANDEY 10/22/12 11. THE INVESTMENT PROCESS Determine the investment objectives and policies Undertake security analysis Construct a portfolio Review the portfolio Evaluate the performance of the portfolios11BY: PROF. N.N.PANDEY10/22/12 12. TYPES OF INVESTORS The contrarians Trend followers and Hedgers and holders12 BY: PROF. N.N.PANDEY 10/22/12 13. THE INVESTMENT ENVIRONMENT FINANCIAL INSTRUMENTS FINANCIAL INTERMEDIARIES FINANCIAL MARKETS13 BY: PROF. N.N.PANDEY 10/22/12 14. ASSIGNMENT FOR DISCUSSIONS- 1 DIFFERENT KIND OF SECURITIES: FOR EXAMPLE: EQUITY SHARES SWEAT EQUITY NON-VOTING SHARES RIGHT SHARES BONUS SHARES CUMULATIVE PREFERENCE SHARES DEBENTURES BONDS ZERO COUPON BONDS DEEP DISCOUNT BONDS.ETC.14BY: PROF. N.N.PANDEY 10/22/12 15. CASELETS-1: Small Cement Company (SCC) , Efficient Cement Company (ECC) and Big Cement Company (BCC) EVENT PROBABILITY RETURNS (effect on price) SCC ECC BCC 5% decline 20%-5% 0%5% Flat 30%10% 10% 10% 5% increase40%25% 20% 15% 10% increase10% 35% 30% 25% MAKE AN INVESTMENT CHOICE WITH JUST THESE DETAILS.15BY: PROF. N.N.PANDEY 10/22/12 16. EXPECTED RETURNS SCC : 20%* -5% + 30%* 10% + 40%* 25% +10%* 35% = 15.5% ECC : 14% BCC : 12.5%16 BY: PROF. N.N.PANDEY 10/22/12 17. CASELETS 2 & 3 (2) You have invested Rs. 50,000/- , 30% of which is invested in Company A, which has an expected rate of return of 15%, and 70% of which is invested in Company- B, with an expected return of 12%. What is the return on your portfolio? What is the expected percentage rate of return? (3) The current market price of a share is Rs.300/- An investor buys 100 shares. After one year he sells these shares at a price of Rs.360/- and also receives the dividend of Rs.15/- per share. Find out his total return, % return, dividend yield and capital gains and capital gains yield.17BY: PROF. N.N.PANDEY10/22/12 18. SOLUTION - 2 Return on portfolio: Company A : .30 x Rs.50,000 x .15 = Rs.2,250 Company B : .70 x Rs.50,000 x .12 = Rs.4,200TOTAL RETURN : 2,250 + 4,200 = Rs.6,450 Expected percentage rate of return:6,450/ 50,000 x 100 = 12.9%18 BY: PROF. N.N.PANDEY 10/22/12 19. SOLUTION-3 Initial Investment = 300 x 100 = Rs.30,000 Dividend earned = 15 x 100 = Rs. 1,500 Capital gains = ( 360 300 ) x 100 = Rs.6,000 Total Return = 1,500+ 6,000 = 7,500 Total percent Return = 7,500/30,000 x 100= 25% Dividend Yield = 15/300 x 100 = 5% Capital Gains yield = 6,000/30,000 x 100= 20%19BY: PROF. N.N.PANDEY10/22/12 20. CASELETS - 4 Shares A and B have the following probability Distribution of possible future returns: Probability(pi) A (%)B (%)0.1 -15 -200.20100.45200.210 300.125 50 (a) Calculate the expected rate of return for each share and standard deviation ofreturn for each share (b) Calculate the coefficient of variation (c) Which share is less risky. Explain.20BY: PROF. N.N.PANDEY10/22/12 21. SOLUTION- 4 FOR SHARE A: r% pi ripi% (r r) (r-r)2 (r-r)2pi(%) -15 0.1 -1.5-2040040 0 0.20 -525 550.4200010 0.22525 525 0.12.5 20400 40r = 52 =90 Since 2 = 90 , = 90 = 9.5%21 BY: PROF. N.N.PANDEY10/22/12 22. SOLUTION 4 Similarly for share B: Expected rate of return = 19% and S.D. = 17% (b) Coefficient of variation = / r For share A = 9.5% / 5% = 1.9 For share B = 17% / 19% = 0.89 ( C) Share B is less risky than share A. Since coefficient of variation( a measure of relative risk) is smaller for Share B.22 BY: PROF. N.N.PANDEY10/22/12 23. RISK RETURN PROFILE OF TWO ASSET PORTFOLIO Portfolio return, Rp = w1R1 + w2R2 Portfolio risk, 2p = w21 21 + w22 22 +2 w1w2 Cov(R1R2) Here, Cov(R1R2) = 1 2 And, w1+ w2 = 1 Or, we can write , 2p = w21 21 + w22 22 + 2 w1w2 1 2 now, we will examine two special cases of perfect positive correlation and perfect negative correlation which is very significant in portfolio theory.23 BY: PROF. N.N.PANDEY10/22/12 24. RISK RETURN PROFILE OF TWO ASSET PORTFOLIO FIRM 1FIRM 2 Return15%30% S.D.10%20% With perfect positive correlation ( = +1) Portfolio return, Rp = w1R1 + w2R2 Portfolio risk, 2p = w21 21 + w22 22 + 2 w1w2 1 2 = (w1 1 + w2 2)2or, p = w1 1 + w2 224BY: PROF. N.N.PANDEY10/22/12 25. PORTFOLIO RETURN AND RISK WITH C.C. = 1ALL FIGURES IN % W110080 60 50 40 20 0 W2 0 20 4050 60 80 100 Rp1518 21 22.5 24 2730 p1012 14 15 16 18 2025BY: PROF. N.N.PANDEY 10/22/12 26. PORTFOLIO RETURN AND RISK WITH C.C. = - 1 Portfolio return, Rp = w1R1 + w2R2 Portfolio risk, 2p = w21 21 + w22 22 - 2 w1w2 1 2= (w1 1 - w2 2)2 or, p = w1 1 - w2 2 ALL FIGURES IN % W1 100 80 6050 40 200 W20 20 4050 6080 100 Rp 1518 21 22.5 242730 p 104 2 5 8 142026 BY: PROF. N.N.PANDEY 10/22/12 27. FUNDAMENTAL ANALYSIS Equity shares have an economic worth which is based on existing and expected earnings capacity. Fundamental analysis attempts to find out the fair value or intrinsic value of securities so that the investors can decide to buy or not to buy the securities at the current market price. The basic premise is that in the long run, the market price tends to move towards its fair or intrinsic value. Small investors sometimes take narrow approach to fundamental analysis which is called bottom-up-approach. However, a broader framework for fundamental analysis is known as top- down-approach or Economic-Industry-Company (EIC) Approach.27 BY: PROF. N.N.PANDEY10/22/12 28. FUNDAMENTAL ANALYSISECONOMYINDUSTRY COMPANYE-I-C ANALYSIS28 BY: PROF. N.N.PANDEY10/22/12 29. VARIABLES AND TECHNIQUES FOR ECONOMIC ANALYSIS There are several indicators which can be used to identify the state of economy like: Gross domestic product (GDP) Business cycles viz. depression, recovery, boom, recession Inflation Interest rates Monetary policy, money supply, and liquidity Industrial growth rate sect oral and total Agricultural output and rainfall pattern Fiscal policy of the Government Foreign exchange reserves Growth of infrastructural facilities29 BY: PROF. N.N.PANDEY 10/22/12 30. VARIABLES AND TECHNIQUES FOR ECONOMIC ANALYSIS Global Economic scenario and confidence General Economic sentiments and confidence in the economy Economic and political stability SOURCES OF INFORMATION FOR ECONOMIC ANALYSIS Reserve bank of India, monthly bulletin. Reserve bank of India, Annual Reports. RBI, Reports on currency and finance, different issues. Statistics on Indian Economy, RBI. Centre for Monitoring of Indian Economy (CMIE), monthly reviews and annual reports Economic surveys, Government of India, different issues Public enterprise survey, GOI30BY: PROF. N.N.PANDEY10/22/12 31. IMPORTANCE OF INDUSTRY ANALYSIS Firms in each different industry typically experience similar levels of risk and similar rates of returns. As such, industry analysis can also be useful in knowing the investment worthiness of a firm. Mediocre stocks in a growth industry usually outperform the best stocks in a stagnant industry. This points out the need for knowing not only company prospects but also industry prospects.31BY: PROF. N.N.PANDEY 10/22/12 32. CLASSIFICATION OF INDUSTRIES PRODUCT LINE WISE : Automobiles, steel, cement, textiles etc. SECTOR WISE : Agriculture, mining, construction, manufacturing, IT, services, transportation etc. BUSINESS CYCLE WISE: Growth , cyclical and defensive32 BY: PROF. N.N.PANDEY 10/22/12 33. KEY INDICATORS IN INDUSTRY ANALYSIS The analysts is free to choose his or her own indicators for analyzing the prospect of an Industry. However , many commonly adopt the following indicators. (A) Performance factors like: Past sales at least for three years Future sales for at least two years Past earnings at least for three years Future earnings for at least two years (B) Environment factors like: Attitude of government Lab our conditions Competitive conditions Technological progress (C) Industry life cycle (pioneering/growing/stagnation/decline) (D ) SWOT analysis for the industry33BY: PROF. N.N.PANDEY 10/22/12 34. SOME RELEVANT QUESTIONS FOR INDUSTRY ANALYSIS Are the sales of industry growing in relation to the growth in Gross National product( GNP) ? What is overall return on investment (ROI) ? What is the cost structure of the industry ? Is the industry in a stable position ? Does the success or failure depend upon any singlecritical factor ? What is the impact of taxation upon the industry ? Are there any statutory controls in matters of raw materials prices, distribution etc ? What is the industrial relations scenario of the industry ? Is the industry highly competitive ? Is it dominated by one or two major companies ?Are they Indian or foreign ? Is there sufficient export potential ?Are international pricescomparable to domestic prices ?34BY: PROF. N.N.PANDEY 10/22/12 35. COMPANY ANALYSIS The basic objective of company analysis is to identify better performing companies in an industry. Various steps involved are as follows: 1.Analysis of the management of the company to evaluate its trust-worthiness and its capacity and efficiency to counter any untoward situation in the industry. 2.Analysis of the financial performance of the company to forecast the future expected earnings capacity. 3.Evaluation of long term vision and strategies of the company in terms of the organizational strength and resources of the company, and 4.Analysis of key success factor for a particular industry and the strength of the particular firm in respect of that factor.35 BY: PROF. N.N.PANDEY10/22/12 36. COMPANY ANALYSIS The ultimate objectives of company analysis are: 1.To analyze the past as well as present earnings to forecast the future earnings of the company. 2.To find out the fair value (intrinsic value) of the share. ANALYZING COMPANYS EARNINGS WITH THE HELP OF FOLLOWING RATIOS: i.EBIT/PBT/PAT ii. RETURN ON EQUITY(ROE) iii.EARNINGS PER SHARE (EPS) iv. DIVIDEND PER SHARE(DPS) v.DIVIDEND PAYOUT RATIO( DP RATIO) vi. PRICE EARNING RATIO ( PE RATIO) vii.MARKET TO BOOK VALUE RATIO (PB RATIO) viii. YIELD36 BY: PROF. N.N.PANDEY10/22/12 37. SOME RELEVANT QUESTIONS IN COMPANY SELECTION What is the size of the company and its relative position in the industry? What is the quality of the companys management? What are the investment programmes and financing plan of the company? What is the track record of the company? What is the financial position of the company? What are the growth prospects of the company? What is the valuation of the companys stock?37 BY: PROF. N.N.PANDEY10/22/12 38. MODEL FRAMEWORK FOR INTEGRATED FINANCIAL ANALYSIS ( FOR 5 YEARS) Analysis of profitability Overall ratio analysis to evaluate the performance and financial position Analysis of quality of current assets, loans and advances Analysis of crucial notes to the accounts and financial policies Analysis of Auditors reports Analysis of quality of earnings Analysis of dividend policies Analysis of cash flow statement Analysis of capital market valuation Analysis of corporate governance report / Directors report Strategic issues emanating out of analysis.38 BY: PROF. N.N.PANDEY10/22/12 39. DISCUSS BASED ON RISK Long SAIL Long SAIL & Long TISCO Long SAIL & Long HUL Long HUL, Long TISCO, Long ACC & Long INFOSYS.39 BY: PROF. N.N.PANDEY 10/22/12 40. EFFICIENT MARKET THEORY Stock prices are determined by a number of factors such as fundamental factors,technical factors and psychological factors. The behavior of stock prices is studied with the help of different methods such asfundamental analysis and technical analysis. Fundamental analysis seeks to evaluate the intrinsic value of securities by studying thefundamental factors affecting the performance of the economy, industry and companies. The basic assumption of Technical analysis is that stock price movement is quite orderlyand not random. It tries to study the patterns in stock price behavior through charts andpredict the future movement in prices. There is a third theory on stock prices behavior which questions this assumptions. This theory came to be known as Random Walk Theory because of its principalcontention that share price movements represent a random walk rather than an orderlymovement.40BY: PROF. N.N.PANDEY10/22/12 41. RANDOM WALK THEORY A change occurs in the price of a stock only because of certain changes in the economy, industry, or company. Information about these changes alters the stock prices immediately and the stock moves to a new level, either upwards or downwards, depending on the type of information. This rapid shift to a new equilibrium level whenever new information is received, is a recognition of the fact that all information which is known is fully reflected in the price of the stock. Further change in the price of the stock will occur only as a result of some other new piece of information which was not available earlier.41 BY: PROF. N.N.PANDEY 10/22/12 42. RANDOM WALK THEORY Thus, according to this theory, changes in stock prices show independent behaviour and are dependent on the new pieces of information that are received but within themselves are independent of each other. Each price change is independent of other price changes because each change is caused by a new piece of information. The basic premise in Random walk theory is that the information on changes in the economy, industry and company performance is immediately and fully spread so that all investors have full knowledge of the information. There is an instant adjustment in stock prices either upwards or downwards. Thus, the current stock price fully reflects all available information on the stock.42BY: PROF. N.N.PANDEY10/22/12 43. RANDOM WALK THEORY Therefore, the price of a security two days ago can in no way help in speculating the price two days later. The price of each day is independent. It may be unchanged, higher or lower from the previous price, but that depends on new pieces of information being received each day. The Random walk theory presupposes that the stock markets are so efficient and competitive that there is immediate price adjustment. This is the result of good communication system. Thus, the random walk theory is based on the hypothesis that the stock markets are efficient. Hence, this theory later came to be known as the efficient market theory or efficient market hypothesis ( EMH)43BY: PROF. N.N.PANDEY 10/22/12 44. EFFICIENT CAPITAL MARKET An efficient capital market is one in which security prices equal their intrinsic values at all times, and where most securities are correctly priced. This happens because of the followings: Large number of investors in the market Free flow of information to all the investors Every investor is capable to interpret the information Every kind of price-sensitive information is discounted in the pricesimmediately No one is in a position to influence the market unduly.44 BY: PROF. N.N.PANDEY10/22/12 45. INDIAN STOCK MARKET MOVING TOWRDS EFFICIENCY In the last 15-20 years several procedural and regulatory changes have been introduced to achieve market efficiency viz. Automated / Online Trading System Depository System Changes in Settlement System Ban on Badla Introduction of Derivatives Provision of full disclosure and transparency Provision to check insider trading Corporatization of Stock Exchanges45BY: PROF. N.N.PANDEY 10/22/12 46. FORMS OF MARKET EFFICIENCY The capital market is considered to be efficient in three different forms: the weak form, semi-strong form and the strong form. THE WEAK FORM OF THE EFFICIENT MARKET HYPOTHESIS (EMH) says that the current prices of stocks already fully reflect all the information that is contained in the historical sequence of prices. The new price movements are completely random. They are produced by new pieces of information and are not related or dependent on past price movements. Therefore, there is no benefit in studying the historical sequence of prices to gain abnormal returns from trading in securities. The weak form of the efficient market hypothesis is thus a direct repudiation of technical analysis.46 BY: PROF. N.N.PANDEY10/22/12 47. SEMI STRONG FORM OF THE EFFICIENT MARKET HYPOTHESIS It says that current prices of stocks not only reflect all informational content of historical prices, but also reflect all publicly available information about the company being studied. Examples of publicly available information are corporate annual reports, company announcements, press releases, announcements of forthcoming dividends, stock splits etc. The semi-strong hypothesis maintains that as soon as the information becomes public the stock prices change and absorb the full information. The implication of semi-strong hypothesis is that fundamental analysts cannot make superior gains by undertaking fundamental analysis because stock prices adjust to new pieces of information as soon as they are received. There is no time gap in which a fundamental analysts can trade for superior gains. Thus, the semi-strong hypothesis repudiates fundamental analysis.47 BY: PROF. N.N.PANDEY 10/22/12 48. STRONG FORM OF THE EFFICIENT MARKET HYPOTHESIS The strong form of the efficient market hypothesis maintains that the current security prices reflect all information both publicly available information as well as private or inside information. This implies that no information, whether public or inside, can be used to earn superior returns consistently. The directors of companies and other person occupying senior management positions within companies have access to much information that is not available to the general public. This is known as inside information. Mutual funds and other professional analysts who have large research facilities may gather much private information regarding different stocks on their own. These are private information not available to the investing public at large.48 BY: PROF. N.N.PANDEY 10/22/12 49. STRONG FORM OF THE EFFICIENT MARKET HYPOTHESIS The strong form efficiency tests involve two type of tests. The first type of tests attempt to find whether those who have access toinside information have been able to utilize profitably such insideinformation to earn excess return. The second type of tests examine the performance of mutual funds and therecommendations of investment analysts to see if these have succeeded inachieving superior returns with the use of private information generated bythem. The results of research on strong form EMH may be summarized as follows:(a) Inside information can be used to earn above average returns.(b) Mutual Funds and investment analysts have not been able to earn superiorreturns by using their private information. In conclusion, it may be stated that the strong form hypothesis is Invalid as regards inside information, but valid as regards private Information other than inside information.49 BY: PROF. N.N.PANDEY 10/22/12 50. SHARE VALUATION MODEL The valuation model used to estimate the intrinsic value of a share is the present valuemodel. The intrinsic value of a share is the present value of all future amounts to be received inrespect of the ownership of that share, computed at an appropriate discount rate. In other words, the intrinsic value of a share is the present value of all the future benefitsexpected to be received from that share. ONE YEAR HOLDING PERIOD:S0 = D1/ (1 + K )1 + S1/ (1 + K )1Here, D1 = Amount of dividend expected to be received atthe end of one year.S1= selling price expected to be realized on sale of the share at the end of one year.K = Rate of return required by the investor.50 BY: PROF. N.N.PANDEY 10/22/12 51. EXAMPLE Suppose, an investor expects to get Rs. 3.50 as dividend from a share next year and hopes to sell off the share at Rs. 45 After holding it for one year, and if his required rate of return Is 25%, the present value of this share to the investor can be Calculated as follows:S0 = 3.5 / 1.25 + 45 / 1.25 = 2.8 + 36 = Rs. 38.8 This is the intrinsic value of the share. The investor would buy This share only if its market price is lower than this value.51 BY: PROF. N.N.PANDEY10/22/12 52. MULTIPLE YEAR HOLDING PERIODS0 = D1 / (1+K)1 + D2 / (1+K)2 + D3 / (1+K)3+ + ( Dn + Sn ) / (1+K)nHere, D1, D2, D3 , Dn = Annual dividends to be received each year Sn = sale price at the end of the holding periodk = investors required rate of returnn = holding period in years EXAMPLE: suppose an investor expects to get Rs. 3.5, 4, and 4.5 as dividend from a share during the next three years and Hopes to sell it off at Rs. 75 at the end of the third year and if his required rate of return is 25%, the present value of this Share to the investor can be calculated as follows:S0 = 3.5 / (1.25)1 + 4 / (1.25)2 + 4.5 / (1.25)3 + 75 / (1.25)3= 2.8 + 2.56 + 2.3 + 38.4 = 46.0652 BY: PROF. N.N.PANDEY 10/22/12 53. CONSTANT GROWTH MODEL OR GORDONS SHARE VALUATION MODEL S0 = D1 / K g or D0 (1 + g) / k g Here , g = expected dividend growth rate According to this model, the intrinsic value of a share is equal To next years expected dividend divided by the difference Between the appropriate discount rate for the stock and its Expected dividend growth rate. Suppose, a company has declared a dividend of Rs. 2.5 per Share for the current year. The company has been following A policy of enhancing its dividends by 10% every year and is Expected to continue this policy in future also. An investor who is considering the purchase of the share of this company Has a required rate of return of 15%. The intrinsic value of share will be 2.5 (1.10) / 0.15 0.10= 2.75/.05 = Rs. 55 The investor would be advised to purchase the share if the current Market price is lower than Rs.55.53BY: PROF. N.N.PANDEY10/22/12 54. MULTIPLE GROWTH MODEL The constant growth assumption may not be realistic in many situations. A typical situation for many companies may be that a period of extraordinary growth (either good or bad) will prevail for a certain number of years, after which growth will change to a level at which it is expected to continue indefinitely. This situation can be represented by a two-stage growth model. In this model, the future time period is viewed as divisible into two different growth segments, the initial extraordinary growth period and the subsequent constant growth period. During initial period growth rates will be variable from year to year, while during the subsequent period the growth rate will remain constant from year to year. The investor has to forecast the time N up to which growth rates would be variable and after which the growth rate would be constant.54BY: PROF. N.N.PANDEY 10/22/12 55. MULTIPLE GROWTH MODEL This would mean that the present value calculations will have to be spread over two phases, where one phases would last until time N and the other would begin after time N to infinity. The intrinsic value of the share is then the sum of the present values of two dividends flows : (a) the flow from period 1 to N which we will call V 1 and (b) the flow from period N+1 to infinity, referred to as V2. This means:S 0 = V 1+ V 2and, V1 = D1 / ( 1+ K )1 + D2 / (1+ K)2 + .+ DN / (1+K)NV2 = DN ( 1+ g ) / (k g ) (1+K)N55 BY: PROF. N.N.PANDEY10/22/12 56. EXAMPLE A company paid a dividend of RS. 1.75 per share during the Current year. It is expected to pay a dividend of Rs. 2 per Share during the next year. Investors forecast a dividend of RS.3 and Rs. 3.50 per share respectively during the two Subsequent years. After that it is expected that annual Dividends will grow at 10% per year into an indefinite future. If the investors required rate of return is 20%, the intrinsic Value of the share can be calculated as follows: V1 = 2 / (1.2)1 + 3/ (1.2)2 + 3.5 / (1.2)3= Rs. 5.78V2 = 3.5(1.1) / (0.20- 0.10)(1.2)3 = 3.85/ (.10)(1.2)3 = Rs. 22.28 We know, S0 = V1+ V2= 5.78 + 22.28 = 28.0656BY: PROF. N.N.PANDEY 10/22/12 57. MULTIPLIER APPROACH TO SHARE VALUATION Many investor and analysts value shares by estimating an appropriate multiplier for the share. The price-earnings ratio (P/E ratio) is the most popular multiplier used for the purpose. P/E ratio = share price / EPS The intrinsic value of a share is taken as the current earnings per share or the forecasted future earnings per share times the appropriate P/E ratio for the share. For example, if the current EPS of a share is Rs. 8 and if the investor feels that appropriate P/E ratio for the share is 12, then the intrinsic value of the share would be taken as Rs. 96. Investment decision to buy or sell the share would be taken after comparing this intrinsic value with the current market price of the share.57 BY: PROF. N.N.PANDEY 10/22/12 58. ASSIGNMENT FOR DISCUSSION- 2 NEW ISSUE MARKET OR PRIMARY MARKET AND ITS FUNCTIONS PARTIES INVOLVED: Manager to the issue Registrar to the issue Underwriters Bankers to the issue Government and statutory agencies etc. PLACEMENT TO THE ISSUE Offer through prospectus Bought out deals Private placement Right issue Book building etc58BY: PROF. N.N.PANDEY10/22/12 59. ASSIGNMENT FOR DISCUSSION- 2 GREEN SHOE OPTION RED HERRING PROSPECTUS E-IPO QUALIFIED INSTITUTIONAL BUYERS (QIBs) STOCKINVEST FUNCTIONS AND POWER OF SEBI SECONDARY MARKET PRIMARY VS. SECONDARY MARKET FUNCTIONS OF SECONDARY MARKET PRINCIPAL WEAKNESSES OF INDIAN STOCK MARKET59 BY: PROF. N.N.PANDEY10/22/12 60. PORTFOLIO SELECTION THROUGH MARKOWITZ MODEL The objective of every rational investor is to maximize his returns and minimize the risk . Diversification is the method adopted for reducing risk. It essentially results in the construction of portfolios. The proper goal of portfolio construction would be to generate a portfolio that provides the highest return and the lowest risk. Such a portfolio would be known as the optimal portfolio or efficient portfolio. The process of finding the optimal portfolio is described as portfolio selection The conceptual framework and analytical tools for determining the optimal portfolio in disciplined and objective manner have been provided by Harry Markowitz. His method of portfolio selection has come to known as the MAROWITZ MODEL. In fact MM is the base of modern portfolio theory.60 BY: PROF. N.N.PANDEY10/22/12 61. FEASIBLE SET OF PORTFOLIOS With a limited number of securities an investor can create a very large number of portfolios by combining these securities in different proportions. This is also known as the portfolio opportunity set . Each portfolio in the opportunity set is characterized by an expected return and a measure of risk ,viz.,variance or standard deviation of returns. Not every portfolio in the opportunity set is of interest to an investor. In the opportunity set some portfolios will obviously be dominated by others. A portfolio will dominate another if it has either a lower standard deviation and the same expected return as the other, or a higher expected return and the same standard deviation as the other. Portfolios that are dominated by other portfolios are known as inefficient portfolios.61 BY: PROF. N.N.PANDEY10/22/12 62. EFFICIENT SET OF PORTFOLIOS PORTFOLIO NO. EXPECTED RETURN(%)STANDARD DEVIATION 15.6 4.5 27.8 5.8 39.2 7.6 410.58.1 511.78.1 612.49.3 713.59.5 813.511.3 915.712.7 10 16.812.962BY: PROF. N.N.PANDEY10/22/12 63. EXERCISE-1 A share is currently selling for Rs.65/-. The company is expected to Pay a dividend of Rs. 2.50 on the share at the end of the year. It is reliably Estimated that the share will sell for Rs.78/- at the end of the year. A. Assuming that the dividend and prices forecasts are accurate, would you buy the share to hold it for one year, if your required rate of return were 12% ? B. Given the current price of Rs.65/- and the expected dividend of Rs.2.50, what would the price have to be at the end of one year to justify purchase of the share today, if your required rate of return were 15% ?63 BY: PROF. N.N.PANDEY10/22/12 64. SOLUTION A. The share valuation model for one year holding period is:S0 = D1/ (1 + K )1 + S1/ (1 + K )1= 2.5/1.12 + 78 / 1.12= 2.23 + 69.64 = 71.87 Since, the current price i.e Rs. 65 is lower than the intrinsic Value of the share i.e. 71.87, the share is under priced and can be bought. B. 65 = 2.5 / 1.15 + X / 1.15 Or, X = 72.25 A selling price of Rs. 72.25 at the end of the year would justify The purchase of the share at current price of Rs.65.64 BY: PROF. N.N.PANDEY10/22/12 65. EXERCISE-2 A company paid dividends amounting to Rs. 0.75 per share during the last year. The company is expected to pay Rs. 2 per share during the next year. Investors forecast a dividend of Rs.3 per share in the year after that. Thereafter, it is expected that dividends will grow at 10% per year into an indefinite future. Would you buy/sell the share if the current price of the share is Rs. 54? Investors required rate of return is 15%.65BY: PROF. N.N.PANDEY10/22/12 66. ANSWER S0 = V1 + V2 V1 = 2 / (1+0.15)1 + 3 / ( 1+ 0.15)2 = 1.74 + 2.27 = 4.01 V2 = 3( 1+ 0.10) / ( 0.15 0.10 ) ( 1+0.15)2= 3.3 / ( 0.05) ( 1.15)2 = 49.91 S0 = 4.01 + 49.91 = 53.92 The current market price of the share ( Rs. 54 ) is equal to The intrinsic value ( Rs. 53.92). As the share is fairly priced No trading is recommended.66BY: PROF. N.N.PANDEY 10/22/12 67. CAPITAL ASSET PRICING MODEL ( CAPM ) The model was developed in mid- 1960s by three researchers William Sharpe, John Lintner and Jan Mossin. The CAPM is really an extension of the portfolio theory of Markowitz. The portfolio theory is a description of how rational investors should build efficient portfolios and select the optimal portfolios. The CAPM derives the relationship between the expected return and risk of individual securities and portfolios in the capital markets if everyone behaved in the way the portfolio theory suggested.67 BY: PROF. N.N.PANDEY10/22/12 68. CAPITAL ASSET PRICING MODEL ( CAPM ) We have discussed earlier that the total risk of a security as measured by standard deviation is composed of two components : systematic risk and unsystematic risk or diversifiable risk. As investment is diversified and more and more securities are added to a portfolio, the unsystematic risk is reduced. For a very well diversified portfolio, unsystematic risk tends to become zero and the only relevant risk is systematic risk measured by beta () . Hence, it is argued that the correct measure of a securitys risk is beta. It follows that the expected return of a security or a portfolio should be related to the risk of that security or portfolio as measured by .68 BY: PROF. N.N.PANDEY 10/22/12 69. CAPITAL ASSET PRICING MODEL ( CAPM ) Beta is a measure of the securitys sensitivity to changes in market return. Beta values greater than one indicates higher sensitivity to market changes, whereas beta value less than one indicates lower sensitivity to market changes. A value of one indicates that the security moves at the same rate and in the same direction as the market. Thus, the beta of the market may be taken as one. The relationship between expected return and beta of a security can be determined graphically. Let us consider an XY graph where expected returns are plotted on the Y axis and beta coefficients are plotted on the X axis. A risk free asset has an expected return equivalent to Rf and beta coefficient of zero. The market portfolio M has a beta coefficient of one and expected return equivalent to Rm. A straight line joining these two points is known as the security market line ( SML ). This is illustrated in next figure.69 BY: PROF. N.N.PANDEY10/22/12 70. CAPITAL ASSET PRICING MODEL ( CAPM )EM E(Rm) Rf1 BETA70 BY: PROF. N.N.PANDEY10/22/12 71. CAPITAL ASSET PRICING MODEL ( CAPM ) The security market line provides the relationship between the expected return and beta of a security or portfolio. This relationship can be expressed in the form of the following equation : Ri = Rf + i ( Rm - Rf ) A part of the return on any security or portfolio is a reward for bearing risk and the rest is the reward for waiting , representing the time value of money. The risk free rate, Rf ( which is earned by a security which has no risk ) is the reward for waiting. The reward for bearing risk is the risk premium.71 BY: PROF. N.N.PANDEY10/22/12 72. CAPITAL ASSET PRICING MODEL ( CAPM ) The risk premium of a security is calculated as the product of beta and the risk premium of the market which is the excess of expected market return over the risk free return, that is ( Rm - Rf ), thus expected return on a security = risk free return + ( beta X risk premium of market ) To illustrate the application of CAPM, let us consider a simple example. There are two securities P and Q having values of beta as 0.7 and 1.6 respectively. The risk free rate and expected market return are assumed to be 6% and 15%. The expected return on security P may be worked out as shown below: 6 + 0.7 ( 15 6 ) = 12.3% The expected return on Q = 6 + 1.6 ( 15 6 ) = 20.4%72BY: PROF. N.N.PANDEY 10/22/12 73. CAPITAL ASSET PRICING MODEL ( CAPM ) Security P with a beta of 0.7 has an expected return of 12.3% whereas security Q with a higher beta of 1.6 has a higher expected return of 20.4%. CAPM represents one of the most important discoveries in the field of finance . The model postulates that systematic risk is the only important ingredient in determining expected return. As investors can eliminate all unsystematic risk through diversification, they can be expected to be rewarded only for bearing systematic risk and not total risk.73BY: PROF. N.N.PANDEY10/22/12 74. PRICING OF SECURITIES WITH CAPM The CAPM can also be used for evaluating the pricing of securities. It provides a framework for assessing whether a security is underpriced, overpriced or correctly priced. According to CAPM, each security is expected to provide a return commensurate with its level of systematic risk. A security may be offering more returns than the expected returns, making it more attractive. On the contrary, another security may be offering less return than the expected return, making it less attractive. The expected return on a security can be calculated using the CAPM formula. Let us designate it as the theoretical return.74BY: PROF. N.N.PANDEY10/22/12 75. PRICING OF SECURITIES WITH CAPM The real rate of return or estimated return to be realized from investing in a security can be calculated as follows : Ri = ( P1 P0 ) + D1 / P0 Here, Ri = The estimated returnP0 = Current market priceP1 = Estimated market price after one yearD1 = Anticipated dividend for the year If the expected return on a security calculated according to CAPM is lower than the actual or estimated return offered by that security, the Security will be considered to be underpriced otherwise overpriced.75 BY: PROF. N.N.PANDEY 10/22/12 76. EXAMPLE SecurityEstimated Return (%)Beta A301.6 B 24 1.4C 181.2 D15 0.9 E15 1.1 F12 0.7 The risk free rate of return is 10%, while the market return is Expected to be 18%.76 BY: PROF. N.N.PANDEY10/22/12 77. EXAMPLE We can use CAPM to determine which of these securities are correctly priced. For this we have to calculate the expected return on each security using the CAPM equation :Ri = R f + i ( R m - Rf )Given that Rf = 10 and Rm = 18A = 10 + 1.6 ( 18 10) = 10 + 12.8 = 22.8% Similarly, the expected return on each security can be Calculated by substituting the beta value of each security In the equation.77BY: PROF. N.N.PANDEY 10/22/12 78. EXAMPLE The expected return according to CAPM and the estimated return of eachsecurity are tabulated below:SECURITYEXPECTED RETURNESTIMATED RETURN( CAPM)A22.830B21.2 24C19.618D17.215E18.815F 15.612 Securities A and B provide more return than the expected return and hence maybe assumed to be underpriced. C,D,E,and F are overpriced.78BY: PROF. N.N.PANDEY10/22/12 79. EXERCISE 1 A security pays a dividend of Rs 3.85 and sells currently at Rs. 83. The security is expected to sell at Rs. 90 at the end of the year. The security has a beta of 1.15. The risk free rate is 5% and the expected return on market index is 12%. Assess whether the security is correctly priced.79BY: PROF. N.N.PANDEY 10/22/12 80. SOLUTION -1 To assess whether a security is correctly price, we need to calculate (a) theexpected return as per CAPM formula, and (b) the estimated return : EXPECTED RETURN : Ri = R f + i ( R m - Rf ) = 5 + 1.15 ( 12 5 ) = 13.05% ESTIMATED RETURN :Ri = ( P 1 P 0 ) + D 1 / P 0= ( 90 83 ) + 3.85 / 83= 13.07% As the estimated return on the security is more or less equal to the expected Return, the security is fairly priced.80 BY: PROF. N.N.PANDEY10/22/12 81. EXERCISE 2 The following data are available to you as portfolio manager : security estimated return ( %) beta standard deviation(%) A 302.050 B25 1.540 C 201.030 D11.50.8 25 E10.00.5 20 Market index 15 1.018 Govt. security 70 0(a)In terms of the security market line, which of the securities listed above are underpriced? (b) Assuming that a portfolio is considered using equal proportions of the five securities listed above, calculate the expected return and risk of Such a portfolio81 BY: PROF. N.N.PANDEY10/22/12 82. SOLUTION - 2 Expected return using CAPM model: A = 23% , B = 19% , C = 15% ,D = 13.4% , E = 11% Securities A, B and C are underpriced. Systematic risk of the portfolio( p ) = 1.16 Expected return of portfolio using CAPM = 16.28%82BY: PROF. N.N.PANDEY 10/22/12 83. MEASUREMENT OF SYSTEMATIC RISK ( ) Systematic risk is the variability in security returns caused by changes in the economy or the market. All securities are affected by such changes to some extent, but some securities exhibit greater variability in response to market changes. Such securities are said to have higher systematic risk. The average effect of a change in the economy can be represented by the change in the stock market index. The systematic risk of a security can be measured by relating that securitys variability with the variability in the stock market Index. A higher variability would indicate higher systematic risk and vice versa.83 BY: PROF. N.N.PANDEY 10/22/12 84. MEASUREMENT OF SYSTEMATIC RISK ( ) The systematic risk of a security is measured by a statistical measure called Beta. The input data required for the calculation of beta are the historical data of returns of the individual security as well as the returns of a representative stock market index. Two statistical methods may be used for the calculation of beta, namely correlation method or the regression method. The regression model postulates a linear relationship between a dependent variable and an independent variable. The model helps to calculate the values of two constants, namely and 84 BY: PROF. N.N.PANDEY 10/22/12 85. MEASUREMENT OF SYSTEMATIC RISK ( ) Beta measures the change in the dependent variable in response to unit change in the independent variable, while alpha measures the value of the dependent variable even when the independent variable has zero value. The regression equation is as follows: Y= + x where, Y = dependent variablex = independent variable and are constants. The formula for and are : = Y - xand = nXY (X)(Y)/ nX2 (X)285BY: PROF. N.N.PANDEY10/22/12 86. MEASUREMENT OF SYSTEMATIC RISK ( ) Where , n = number of items Y = Mean value of the dependent variable scoresX = Mean value of independent variable scoresY = dependent variable scoresX = independent variable scores For the calculation of beta, the return of the individual security is taken as the dependent variable, and the return of the market index Is taken as the independent variable. The regression equation is : Ri = + Rm Here , Ri = Return of the individual security86BY: PROF. N.N.PANDEY10/22/12 87. MEASUREMENT OF SYSTEMATIC RISK ( ) Rm = Return of the market index = Estimated return of the security when the market is stationary = Change in the return of the individual security in response to unit change in the market index. It is thus, the measure of systematic risk of a security. A security can have betas that are positive, negative or zero. As beta measures the volatility of a securitys return relative to the market, the larger the beta, the more volatile the security. A stock with beta greater than 1.0 has above average risk, 1.0 means average risk and less than 1.0 means lesser risk.87BY: PROF. N.N.PANDEY10/22/12 88. MEASUREMENT OF SYSTEMATIC RISK ( ) For example, when market returns move up by 5%, a stock with beta of 1.5 would find its returns moving up by 7.5 % ( 5x1.5). Similarly, decline in market returns by 5% would produce a decline of 7.5% in the return of the individual security. In using the beta factor for investment, the investor assume that the relationship between the security variability and market variability will continue to remain the same in future also. Thats why beta is calculated from historical data of returns.88BY: PROF. N.N.PANDEY10/22/12 89. EXAMPLE -1 Monthly returns data (in %) are prescribed below for ITC stock and BSE index for a 12 month period: MONTH ITC BSE INDEX 1 9.437.41 20.00- 5.33 3 - 4.31 -7.35 4 - 18.92- 14.64 5- 6.671.58 6 26.5715.19 7 20.00 5.11 8 2.930.76 9 5.25 - 0.9789BY: PROF. N.N.PANDEY10/22/12 90. EXAMPLE-1 MONTHITC BSE INDEX10 21.45 10.4411 23.1317.4712 32.8320.15 CALCULATE BETA OF ITC STOCK. ANS: 1.38490 BY: PROF. N.N.PANDEY 10/22/12 91. ARBITRAGE PRICING MODEL The Arbitrage Pricing Model ( APM) looks very similar to the CAPM, but its features are significantly different. The CAPM is a single factor model whereas the APM is a multi factor model. Arbitrage Pricing Theory , out of which the APM arises, states that the expected return on investment is dependent upon how that investment reacts to a set of individual macro economic factors (the degree of reaction being measured by the betas ) and the risk premium associated with each of those macro-economic factors. Basically, CAPM says that :E ( R i ) = R f + i ( Rm - R f )91BY: PROF. N.N.PANDEY 10/22/12 92. ARBITRAGE PRICING MODEL Let ( Rm - Rf ) is expressed by APM holds that : E(Ri ) = Rf + 1 i1 + 2 i2 + 3 i3 Where , 1 , 2 and 3 are the average risk premium for each of the three factors in the model and i1 , i2 and i3 are measures of the sensitivity of the of the particular security i to each of the three factors. Several factors appear to have been identified as being important viz. changes in the industrial production in the economy, changes in the inflation rate, real interest rate, level of money supply in the economy etc.92BY: PROF. N.N.PANDEY 10/22/12 93. PORTFOLIO REVISION In portfolio management, the maximum emphasis is placed on portfolio analysis and selection which leads to the construction of optimal portfolio. Very little discussion is seen on portfolio revision which is as important as portfolio analysis and selection. The financial markets are continually changing. In this dynamic environment, a portfolio that was optimal when constructed may not continue to be optimal with the passage of time. It may have to be revised periodically so as to ensure that it continues to be optimal.93BY: PROF. N.N.PANDEY10/22/12 94. NEED FOR REVISION The primary factor necessitating portfolio revision is changes inthe financial markets since the creation of the portfolio. But,sometimes it needs to be revised due to investors related factorsalso like: 1. Availability of additional funds for investment 2. Change in risk tolerance 3. Change in the investment goal 4. Need of funds for alternative use. Thus, the need for portfolio revision may arise from changes in the Financial market or changes in the investors position, namely his Financial status and preferences.94BY: PROF. N.N.PANDEY10/22/12 95. MEANING OF PORTFOLIO REVISION A portfolio is a mix of securities selected from a vast universe of securities. Two variables determine the composition of a portfolio ; the first is the securities included in the portfolio and the second is the proportion of total funds invested in each security. Portfolio revision involves changing the existing mix of securities. This may be effected either by changing the securities currently included in the portfolio or by altering the proportion of funds invested in the securities. Portfolio revision thus leads to purchases and sales of securities. The ultimate aim of portfolio revision is maximization of returns and minimization of risk.95 BY: PROF. N.N.PANDEY10/22/12 96. CONSTRAINTS IN PORTFOLIO REVISION Transaction cost Taxes Statutory stipulations Intrinsic difficulty96 BY: PROF. N.N.PANDEY10/22/12 97. PORTFOLIO REVISION STRATEGIES ACTIVE REVISION STRATEGY PASSIVE REVISION STRATEGY OR FORMULA PLANS: 1. CONSTANT RUPEE VALUE PLAN 2. CONSTANT RATIO PLAN 3. DOLLAR COST AVERAGING The choice of the strategy would depend on the investors Objectives, skills, resources and time.97 BY: PROF. N.N.PANDEY10/22/12 98. ACTIVE REVISION STRATEGY Active revision strategy involves frequent and sometimes substantial adjustments to the portfolio. Investors who undertake active revision strategy believe that security markets are not continuously efficient. They believe that securities can be mispriced at times giving an opportunity for earning excess returns through trading in them. Thus, the objective of active revision strategy is to beat the market. Active portfolio revision is essentially carrying out portfolio analysis and portfolio selection all over again. Passive revision strategy, in contrast, involves only minor and infrequent adjustment to the portfolio over time.98BY: PROF. N.N.PANDEY 10/22/12 99. CONSTANT RUPEE VALUE PLAN This is one of the most popular or commonly used formula plans. In this plan, the investor constructs two portfolios, one aggressive, consisting of equity shares and the other, defensive, consisting of bonds and debentures. The purpose of this plan is to keep the value of the aggressive portfolio constant, i.e. at the original amount invested in the aggressive portfolio. As shares prices fluctuate, the value of the aggressive portfolio keeps changing. When share prices are increasing, the total value of the aggressive portfolio increases. The investor has to sell some of the shares99BY: PROF. N.N.PANDEY10/22/12 100. CONSTANT RUPEE VALUE PLAN When share prices are increasing, the total value of the aggressiveportfolio increases. The investor has to sell some of the sharesfrom his portfolio to bring down the total value of the aggressiveportfolio to the level of his original investment in it. The saleproceeds will be invested in the defensive portfolio by buyingbonds and debentures. On the contrary, he will take oppositeaction. Under this plan, the investor is effectively transferring funds fromthe aggressive portfolio to the defensive portfolio and therebybooking profit when share prices are increasing. Funds aretransferred from the defensive portfolio to the aggressive portfoliowhen share prices are low. Thus the plan helps the investor to buyshares when their prices are low and sell when prices are high.100BY: PROF. N.N.PANDEY10/22/12 101. CONSTANT RUPEE VALUE PLAN In order to implement this plan, the investor has to decide theaction points, i.e. when he should make the transfer of funds tokeep the rupee value of the aggressive portfolio constant. Theseaction points, or revision points, should be predetermined andshould be chosen carefully. For instance, the revision points may be predetermined as 10%,15%, 20% etc. above or below the original investment in theaggressive portfolio. If the revision points are too close, the number of transactionswould be more and the transaction costs would increase reducingthe benefits of revision.101BY: PROF. N.N.PANDEY 10/22/12 102. CONSTANT RUPEE VALUE PLAN If the revision points are set too far apart, it may not be possibleto profit from the price fluctuations occurring between theserevision points. Let us consider an investor who has Rs.1,00,000 for investment.He decides to invest Rs. 50,000 in an aggressive portfolio ofequity shares and the remaining Rs. 50,000 in a defensiveportfolio of bonds and debentures. He purchases 1250 sharesselling at Rs. 40 per share for his aggressive portfolio. Therevision points are fixed at 20% above or below the originalinvestment of Rs. 50,000.102 BY: PROF. N.N.PANDEY 10/22/12 103. PORTFOLIO EVALUATION Portfolio evaluation refers to the evaluation of the performance ofthe portfolio. It is essentially the process of comparing the return earned on aportfolio with the return earned on one or more other portfoliosor on a benchmark portfolio. Portfolio evaluation essentially comprises two functions,performance measurement and performance evaluation. Performance measurement is an accounting function whichmeasures the return earned on a portfolio during the holdingperiod or investment period.103BY: PROF. N.N.PANDEY 10/22/12 104. PORTFOLIO EVALUATION Performance evaluation, on the other hand, addresses such issuesas whether the performance was superior or inferior, whether theperformance was due to skill or luck etc. While evaluating the performance of a portfolio, the returnearned on the portfolio has to be evaluated in the context of therisk associated with that portfolio. The first step in portfolio evaluation is calculation of the rate ofreturn earned over the holding period. Return may be defined to include changes in the value of theportfolio over the holding period plus any income earned over theperiod.104BY: PROF. N.N.PANDEY10/22/12 105. PORTFOLIO EVALUATION The rate of return earned by portfolio may be calculated andcompared with the rate of return earned by a representative stockmarket index which can be used as a benchmark for comparativeevaluation. The portfolio may also be ranked in descending order of theirrates of return. But such straight forward rates of returncomparison may be incomplete and sometimes even misleading. The differential return earned by portfolio could be due entirelyto the differential risk exposure of the portfolio. Hence, thereturns have to be adjusted for risk before making anycomparision.105BY: PROF. N.N.PANDEY10/22/12 106. RISK ADJUSTED RETURNS One obvious method of adjusting for risk is to look at the rewardper unit of risk. Thus, the reward per unit of risk for different portfolios or mutualfunds may be calculated and the funds may be ranked indescending order of the ratio. A higher ratio indicates betterperformance. Two methods of measuring the reward per unit of risk have beenproposed by William Sharpe and Jack Trey nor respectively intheir pioneering work on evaluation of portfolio performance.106BY: PROF. N.N.PANDEY10/22/12 107. SHARPE RATIO The sharpe ratio is also known as the reward to variability ratio . It is the ratio of the reward or risk premium to the variability ofreturn or risk as measured by the standard deviation of return. The formula is: Sharpe ratio ( SR) = rp rf / p Where, rp = Realized return on the portfoliorf = Risk free rate of return p = Standard deviation of portfolio return107BY: PROF. N.N.PANDEY10/22/12 108. TREYNOR RATIO The Trey nor ratio is also known as the reward to volatility ratio. It is the ratio of the reward or risk premium to the volatility ofreturn as measured by the portfolio beta. The formula is : Trey nor ratio ( TR) = rp rf / p Where, rp = Realized return on the portfoliorf = Risk free rate of return p = portfolio betaTo understand the calculation of the two ratiosLet us consider an example:108BY: PROF. N.N.PANDEY10/22/12 109. EXAMPLE FUND RETURN(%) STANDARD DEVIATION (%) BETA A 12 18 0.7 Z 19 25 1.3M(market index) 1520 1.0The risk free rate of return is 7%.The SR for the three funds are:A = 12 7 / 18 = 0.277Z = 19 7 / 25 = 0.48 M = 15 7 / 20 = 0.40AS PER SHARPES PERFORMANCE MEASURE, FUND Z HAS PERFORMEDBETTER THAN BENCHMARK MARKET INDEX, WHILE FUND A HASPERFORM ED WORSE THAN THE MARKET INDEX.109 BY: PROF. N.N.PANDEY 10/22/12 110. EXAMPLEThe TR for the three funds are : A = 12 7 / 0.7 = 7.14 Z = 19 7 / 1.3 = 9.23M = 15 7 / 1.0 = 8According to Trey nor performance measure also, fund Z has performed betterandFund A has performed worse than the benchmark. Both the ratios are relative measures of performance because they relate thereturn to the risk involved. Sharpe uses the total risk as measured by standard deviation, while Trey noremploys the systematic risk as measured by beta coefficient. For a fully diversified portfolio, Trey nor ratio would be the appropriatemeasure of performance evaluation otherwise we should use Sharpe ratio.110BY: PROF. N.N.PANDEY10/22/12