PMT-F1

7/29/2019 PMT-F1

1/50

Monkey Business

Business Model of a Trader in a village:

Give 1 monkey and get Rs. 10/-

Collects 100 monkeys


Collects 60 monkeys


Collects 40 monkeys

Now offers Rs. 60/- for 1 monkey. No takers!!!

Announces offer open for 2 days only

AAGEY KYA HOTA HAI---------------------????

7/29/2019 PMT-F1

2/50

2

IRRATIONALLYHELD TRUTHSMAY BE MORE

HARMFUL THANREASONEDERRORS

T.H.HUXLEY

7/29/2019 PMT-F1

3/50

3

Portfolio ManagementCapital Market Theory & Asset

Pricing Theory

7/29/2019 PMT-F1

4/50

4

An Introduction to Portfolio Management

Objective: investors maximize returns for a givenlevel of risk.

Investors are risk averse: assuming returns are

equal, they will prefer the less risky asset. Risk aversion implies a positive relationship

between expected return and risk.

Risk is a measure of uncertainty regarding an

investments outcome. Alternatively, risk can beconsidered the probability of a bad outcome.

7/29/2019 PMT-F1

5/50

5

A- The Portfolio Management Process

Elements of Portfolio Management

Evaluating Investor and Market characteristics

Determine the objectives and constraints of the investor

Evaluate the economic environment

Developing an investment policy statement (IPS)

Determining an asset allocation strategy Implementing the portfolio decisions

Measuring and evaluating performance

Monitoring dynamic investor objectives and capital marketconditions

The ongoing portfolio management process can be detailed withthe integrative steps described by planning, execution, andfeedback.

7/29/2019 PMT-F1

6/50

6

Investment Objectives

Investment objectives are concerned with risk and returnconsiderations.

Risk tolerance is the combination of willingness and ability totake risk.

Risk aversion indicates an investors inability and unwillingnessto take risk.

For an individual, risk tolerance may be determined by behavioraland psychological factors, whereas for an institution, thesefactors are primarily determined by portfolio constraints.

Risk objectives can be either absolute (standard deviation of totalreturn) or relative (tracking risk).

7/29/2019 PMT-F1

7/50

7

Return Objectives

Required return can be classified as either a desiredor a required return.

Desired return: how much the investorwishes toreceive from the portfolio.

Required return: some level of return that mustbe

achieved by portfolio. Required return serves as a much stricter benchmark

than desired return. The level of return needs to be consistent with the risk

objectives.

Return should be evaluated on a total return basis:capital gains and current income.

7/29/2019 PMT-F1

8/50

8

Investment Constraints

Investment constraints are those factors limiting the universe ofavailable choices. They include:

1. Liquidity: expected or unexpected cash outflows that will beneeded at some specified time.

2. Time horizon: the time period(s) during which a portfolio is

expected to generate returns to meet major life events. Longertime horizons often indicate a greater ability to take risk, even ifwillingness is not evident.

3. Tax concerns: differential tax treatments are applied toinvestment income and capital gains.

4. Legal and regulatory factors: are externally generatedconstraints that mainly impact institutional investors.

5. Unique circumstances: special concerns of the investor.

7/29/2019 PMT-F1

9/50

9

Diversification and Portfolio Risk

There are two broad classes of risk that

affect portfolios:

Systematic Risk or market risk or non-diversifiable risk determined byMacroeconomic factors (affect wholeeconomy), such as:

Business cycle Inflation rate Interest rate Exchange rate

7/29/2019 PMT-F1

10/50

10


Unsystematic Risk orunique risk orfirm-specific

risk ordiversifiable risk determined by Firm-specific factors, such as:

Firms successful R&D

Managements style and philosophy

Unsystematic risk can be eliminated with

diversification, i.e., spreading out the risk of aportfolio by investing in a variety of securities.

The Total Risk = Systematic Risk + Unsystematic Risk

7/29/2019 PMT-F1

11/50

11


Graph:

7/29/2019 PMT-F1

12/50

12

Utility Function & Indifference Curves

Indifference curves represent different combinationsof risk and return, which provide the same level ofutility to the investor.

An investor is indifferent between any two portfolios

that lie on the same indifference curve. Flat indifference curves indicate that an individual

has a higher tolerance for risk. Very steepindifference curves belong to highly risk-averse

investors. The optimal portfolio offers the greatest amount of

utility to the individual investor.

Convex & positively sloped.

7/29/2019 PMT-F1

13/50

13

return

risk

Highly risk averse

7/29/2019 PMT-F1

14/50

14

return

risk

Highly risk tolerant

7/29/2019 PMT-F1

15/50

15

Markowitz Portfolio Theory

Any asset or portfolio can be described by twocharacteristics:

1. The expected return

2. The risk measure (variance)

Portfolios variance is a function of not only the variance ofreturns on the individual investments in the portfolio, butalso of the covariance between returns of these individualinvestments.

In a large portfolio, the covariances are much moreimportant determinants of the total portfolio variance thanthe variances of individual investments.

7/29/2019 PMT-F1

16/50

16

Markowitzs Assumptions

Investors consider investments as the probabilitydistribution of expected returns over a holdingperiod.

Investors seek to maximize expected utility Investors measure portfolio risk on the basis of

expected return variability

Investors make decisions only on the basis of

expected return and risk For a given level of risk, investors prefer higher

return to lower returns.

7/29/2019 PMT-F1

17/50

17

rp = W1r1 +W2r2W1 = Proportion of funds in Security 1

W2 = Proportion of funds in Security 2r1 = Expected return on Security 1

r2 = Expected return on Security 2

Two-Security Portfolio: Return

WiSi=1

n

= 1

7/29/2019 PMT-F1

18/50

18

sp2= w12s12 + w22s22 + 2W1W2 Cov(r1r2)s12 = Variance of Security 1s22 = Variance of Security 2

Cov(r1r2) = Covariance of returns for

Security 1 and Security 2

Two-Security Portfolio: Risk

7/29/2019 PMT-F1

19/50

19

Covariance

r1,2 = Correlation coefficient ofreturns

Cov(r1r2) = r1,2s1s2

s1 = Standard deviation ofreturns for Security 1s2 = Standard deviation ofreturns for Security 2

7/29/2019 PMT-F1

20/50

20

Correlation Coefficients: Possible

Values

Ifr = 1.0, the securities would beperfectly positively correlated

Ifr = - 1.0, the securities would beperfectly negatively correlated

Range of values forr1,2

-1.0 < r < 1.0

7/29/2019 PMT-F1

21/50

21

The Efficient Frontier

The efficient frontier consists of the set portfoliosthat has the maximum expected return for a givenrisk level.

Optimal portfolio: the portfolio that lies at the point of

tangency between the efficient frontier and his/herutility (indifference) curve.

An investors optimal portfolio is the efficient portfoliothat yields the highest utility.

A risk averse investor has steep utility curves. This curve is convex in shape

7/29/2019 PMT-F1

22/50

22

THE CAPITAL MARKET LINE


M

rP

sP

CML

rfr

Efficient frontier

Optimal portfolio

7/29/2019 PMT-F1

23/50

23

Capital Asset Pricing Model (CAPM)

- William Sharpe

CAPM is a model that predicts the expected return on eachrisky asset. Security Market Line (SML): visually represent the relationship

between systematic risk and the expected or required rate ofreturn on an asset.

Capital Market Line(CML): visually represents the relationshipbetween total risk (std. dev.) and the expected return of theportfolio of assets.

The risk measure of the asset is its systematic risk measuredusing beta ().

E(Ri) = RFR + i(RM-RFR) is standardized because it divides an assets covariance

Cov(i,M) with the market portfolio by the variance of the marketportfolio (M

2). RM-RFR: is the market risk premium

7/29/2019 PMT-F1

24/50

24

Security Market Line

Beta = 1.0 implies asrisky as market

Securities A and Bare more risky thanthe market

Beta > 1.0

Security C is lessrisky than the market

Beta < 1.0

AB

C

E(RM)

RF

0 1.0 2.00.5 1.5

SML

BetaM

E(R)underpriced

overpriced

7/29/2019 PMT-F1

25/50

25

ErUnderpriced SML: Er= rf+ (Erm rf)

Overpriced

rf

Underpriced expected return > required return according to CAPM

lie above SMLOverpriced expected return < required return according to CAPM

lie below SMLCorrectly priced expected return = required return according to CAPM

lie along SML

SML and Asset Values

7/29/2019 PMT-F1

26/50


THE CAPITAL MARKET LINE (CML)

the new efficient frontier that results from risk freelending and borrowing

both risk and return increase in a linear fashionalong the CML

7/29/2019 PMT-F1

27/50

27

CAPM in Details:

What is an equilibrium?

Two-fund separation

Rf

A

Market Portfolio

Q

B

Capital Market Line

p

E(Rp)

E(RM)

M

Th S i M k Li

7/29/2019 PMT-F1

28/50

28

The Security Market Line-

Beta Calculation

The systematic risk is calculated as thecovariance of the returns on security orportfolio i with the returns on the market

portfolio, Cov (Ri, RM), divided by thevariance of the returns on the marketportfolio, 2M :

Betai = Cov (Ri,RM)/ 2

M

7/29/2019 PMT-F1

29/50

29

Calculating BETA

Beta is a standardized measure of systematic risk. It iscalculated as:

i

= covi,M

/ M

= (i

/ M

) x i,MWhere:

covi,M = covariance between stock i and the market portfolio

i = standard deviation of stock i

M = standard deviation of the market portfolio

i,M = correlation coefficient between stock i and the market portfolio

Note that the beta of the market portfolio is one by definition.

M = M / M = 1

7/29/2019 PMT-F1

30/50

30

Example: Calculating Beta

The covariance of stock A with the marketportfolio M (covA,M) is 0.11 and the standarddeviation of the market is 26%. Calculate thebeta of stock A.

Answer:

First, we need to find the variance for themarket. The variance is the standard

deviation squared or 0.0676 (= 0.26). Hence,the beta of stock A is:

A = 0.1100 / 0.0676 = 1.63

7/29/2019 PMT-F1

31/50

31

Using the SML for Security Selection

The SML will tell us assets required returns from the SML,given their level of systematic risk (as measured by beta). Wecan compare this to the assets expected returns (given ourforecasts of future prices and dividends) to identify undervaluedassets and create the appropriate trading strategy.

An asset with an expected return greater than its required returnfrom the SML is undervalued; we should buy it.

An asset with an expected return less than the required returnfrom the SML is overvalued; we should sell it (or short sell it ifwere inclined to be aggressive).

An asset with an expected return equal to its required return fromthe SML is properly valued;were indifferent between buyingand selling it.

7/29/2019 PMT-F1

32/50

32

Example: Using the SML

The following table contains information based on analysts forecasts

for three stocks. The risk-free rate is 7 percent and the expectedmarket return is 15 percent.

Compute the expected and required return on each stock, determinewhether each stock is undervalued, overvalued, or properlyvalued, and outline an appropriate trading strategy.

Stock Price

today

E(Price) in 1

year

E(Divid.) in 1 year Beta

Stock A $25 $27 $1.00 1.0

Stock B 40 45 2.00 0.8

Stock C 15 17 0.49 1.2

7/29/2019 PMT-F1

33/50

33

Example: Using the SML

Answer:Expected and required returns are shown in the figure below:

Stock Expected Return Required Return

A ($27 -$25 +$1) / $25 = 12.0% 0.07 + (1.0) (0.15 0.07) = 15.0%

B ($45 - $40 + $2) / $40 = 17.5% 0.07 + (0.8) (0.15 0.07) = 13.4%

C ($17 - $15 + $0.49) / $15 = 16.6% 0.07 + (1.2) (0.15 0.07) = 16.6%

Stock A is overvalued. It is expected to earn 12%, but based on its systematic riskit should earn 15%.

Stock B is undervalued. It is expected to earn 17.5%, but based on its systematicrisk it should earn 13.4%.

Stock C isproperly valued. It is expected to earn 16.6%, and based on itssystematic risk it should earn 16.6%.

The appropriate trading strategy is: Short sell A, buy B and buy, sell, or ignore C.

7/29/2019 PMT-F1

34/50

34

THE CAPM ASSUMPTIONS

NORMATIVE ASSUMPTIONS

expected returns and standard deviation cover a

one-period investor horizonnonsatiation

risk averse investors

assets are infinitely divisible

risk free asset exists

no taxes nor transaction costs

7/29/2019 PMT-F1

35/50

THE CAPM ASSUMPTIONS

ADDITIONAL ASSUMPTIONS

one period investor horizon for all

risk free rate is the same for all

information is free and instantaneously availablehomogeneous expectations

7/29/2019 PMT-F1

36/50

36

Relaxing the CAPM assumptions

When the assumptions of CAPM are relaxed,the location of the SML will change, andindividual investors will have a new SML.

Taxes: if investors have high tax rates, thenCML and SML could be significantly differentamong investors.

Transaction costs: The cost trading the

security may offset any potential excessreturn resulting from the trade securitieswill plot close to SML but not exactly on it.

7/29/2019 PMT-F1

37/50

37

Homogeneous Expectation: if all investors

had different expectations about risk andreturn, then each would have a unique graphas a result of their divergence ofexpectations.

One-planning period: if one investor uses aone-year planning period and another uses a

one-month planning period, then the twoinvestors have different SML.

P tf li bj ti d th t

7/29/2019 PMT-F1

38/50

38

Portfolio objectives and the common typesof portfolio constraints for individual and

institutional investors

The key for determining individual investor objectivesand constraints is the life cycle approach, whichrefers to the determination of risk- return positions of

individuals at various life cycle changes. For example,younger investors typically can accept more risk thanolder investors. The life cycle approach can bebroken down to 4 phases:

I. accumulation,II. consolidation,

III. spending,

IV. gifting.

7/29/2019 PMT-F1

39/50

39

Accumulation phase - for investors in early tomiddle years of their careers, with low currentwealth relative to their peak wealth years; longterm retirement planning goals, high-riskobjectives.

Consolidation phase for investors in middlecareer, with average current wealth relative totheir peak wealth years; long term retirement

planning; moderate risk objectives.

7/29/2019 PMT-F1

40/50

40

Spending phase for investors in early retirement,wealth is peaking; a major goal is capitalpreservation; conservative risk objectives.

Gifting phase- for investors in early retirement tolate life, major goal estate planning; low riskobjectives.

Individual investor risk and return objectivesconsiderations include:

Clients with a capital preservation objectivehave very low risk tolerance.

Clients with a current income objective want togenerate income to supplement earnings forconsumption. They have a low risk tolerance

(e.g., retirees)

7/29/2019 PMT-F1

41/50

41

Three Forms of Market Efficiency

Prices reflect allinformation from

past prices

Prices reflect all

publicly available

information

Prices reflect all

relevant available

information

Technical Analysis

is valueless

Fundamental

Analysis is

unprofitable

Insider Trading

is unprofitable

Weak Form Semi-strong Form Strong Form

7/29/2019 PMT-F1

42/50

42

Weak Form Efficiency: Tests

A market is weak form efficient if current prices

reflect all information contained in past prices

and price movements.

Implications

Past prices cannot predict price movements in the future.

Trading rules based on technical analysis cannot yield superiorreturns.

Tests

Tests of correlation of prices.

Tests of trading rules.

7/29/2019 PMT-F1

43/50

43

Weak Form: SummaryEvidence in favor

Implications:

Technical rules are useless.

If the price of a stock has just gone up or down, then it does notfollow that it will go up or down in the future.

Based on Random Walk Theory.

Reason:

If technical rules worked, everyone would use them. As a result

they would not work anymore.

This does notimply:

Prices are uncaused.

Markets do not behave according to rules.

Investors are incompetent.

7/29/2019 PMT-F1

44/50

44

Semi-Strong Form Efficiency

A market is semi-strong form efficient if all

publicly available information is reflected in market prices.

Implications: Market reacts to information about companies fundamentals

Macroeconomic news.

News on earnings. Price adjustments are fast and appropriate: no systematic

under/overshooting after announcement.Tests:

Event studies of price reactions to news announcements.

Tests of asset pricing models

Joint hypothesis problem

7/29/2019 PMT-F1

45/50

45

Semi-Strong Form Evidence

Event Studies

Earnings announcements.

Dividend announcements. Leading indicators.

Stock splits.

Accounting changes.

Mergers and acquisitions.

Corporate reconstructions. Block sales.

Rights issues.

Share tips.

M i A t

7/29/2019 PMT-F1

46/50

46

Macroeconomic Announcements

Time Content ofAnnouncement

9.15 am Industrial ProductionCapacity Utilization

10.00 am Business InventoriesConstruction SpendingFactory InventoriesIndustry SurveyNew Single-Family Home

SalesPersonal Income

2.00 pm Budget

Time Content ofAnnoucement

8.30 am ConsumerPrice Index

Durable GoodsOrders

Employment

Gross NationalProduct

Housing StartsMerchandise Trade

Deficit

Leading IndicatorsProducer Price IndexRetail Sales

7/29/2019 PMT-F1

47/50

47

Semi-Strong Form Conclusions

Evidence

Unbiased evaluation by investors.

Pre-announcement information leakage.

Rapid adjustment to new information.

Implications

Fundamental analysis is valueless

Unless it is original, or it incorporates

private information. Check if price has already moved

If not, must be able to act fast!

7/29/2019 PMT-F1

48/50

48

Strong Form Efficiency

A market is strong form efficient if allrelevant information

(public or private) is reflected inmarket prices.Implications:

Analysts knowledge doesnt help.

No profits from insider trading.

Tests:

Profitability of trading on inside information.

Performance of fund managers.

7/29/2019 PMT-F1

49/50

49

Strong Form Evidence

Fund managers performance: Mutual funds

Pension funds

Specialists and insiders Market makers

Corporate officers

Analysts skills Advisory services

Internal research

Transactions analysis

7/29/2019 PMT-F1

50/50

CONCLUSION

CERTAINLY OUR MARKETS ARE NOT PERFECTAND DO NOT QUALIFY FOR STRONG MARKETEFFICENCY.

SO RANDOM WALK THEORY HOLDS TRUE.

STILL AS RETURNS AND RISKS FORM SINGLEMAJOR FACTOR IN PORTFOLIO CHOICE, CAPMIS HERE TO STAY AS A TOOL FOR EFFICIENT

PORTFOLIO MANAGEMENT.

Documents

PMT-F1