P R A V I N M A N D O R A G R O U P T U T I O N S

GAMBLING VS SPECULATION :

Economically speaking, a gamble is the assumption of risk for enjoyment of the risk itself,
whereas speculation is undertaken in spite of the risk involved because one perceives a
favorable risk–return trade-off. To turn a gamble into a speculative venture requires an
adequate risk premium to compensate risk-averse investors for the risks they bear. Hence, risk
aversion and speculation are consistent. Notice that a risky investment with a risk premium of
zero, sometimes called a fair game , amounts to a gamble.

Portfolio is a combination of various types of assets like equity, debt, real estate, metals etc.
Portfolio is made basically to increase return & reduce the risk.

CAPITAL ASSET PRICING MODEL (CAPM)

A method used to estimate the cost of equity is the CAPM approach. The CAPM explains the
behaviour of security prices & provides a mechanism whereby investors could assess the
impact of proposed security investment on their overall portfolio risk & return.

The basic assumptions of this approach are related to (a) the efficiency of the security markets
(b) investor preferences.

The efficient market assumption implies that (1) all investors have common expectations
regarding the expected returns, variances & correlation of returns among all securities (2) all
investors have same information about the securities (3) there are no restrictions on investments
(4) there are no taxes, no transaction costs (5) no single investor can significantly affect the
market price.

The implication of investors’ preference assumption is that all investors prefer the security that
provides the highest return for a given level of risk, that is, they are risk averse.

The risk to which security investment is exposed into 2 groups :

Total Risk = Systematic Risk + Unsystematic Risk.

Systematic Risk & Unsystematic Risk :

When securities are combined into portfolios, risk is reduced. Diversification reduces the risk
when the returns of securities do not vary exactly in the same direction.

The question is : “Can diversification reduce all risk of securities ?” Risk has 2 parts :

 UNSYSTEMATIC RISK or UNIQUE RISK : A part of risk arises from the uncertainties which
are unique to the individual securities & which is diversifiable & so totally possible to reduce.

The examples of this type of risk are :

 Workers declare strike in a company.

 The R & D experts of the company leaves.

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 The company looses a big contract in a bid.

 The company makes a breakthrough in process innovation.
 The Govt. increases customs duty on the material used by the company.

 SYSTEMATIC RISK or MARKET RISK : The other part of the risk arises on the account of the
economy wide uncertainties & the tendency of the individual securities to move together
with changes in the market. This part of risk can not be reduced through diversification & it
is called systematic Or market risk.

The examples of this type of risk are :

 The Govt. change the interest rate policy.
 The corporate tax rate is increased.
 The inflation rate increases.
 The RBI goes for a restrictive credit policy.

According to CAPM approach, only the non-diversifiable risk of an investment is assessed &
in the terms of the beta coefficient. Beta is a measure of the volatility of a security’s return
relative to the returns of a broad-based market portfolio. In other words, it is an index of co-
movement of return on investment with the market return.

With reference to the cost of capital perspective, the CAPM describes the relationship
between the required rate of return or the cost of equity capital & the non-diversifiable risk of
the firm in terms of beta.
Ke = Rf + b (Km – Rf)

Ke = cost of equity capital

Rf = the rate of return required on a risk free investment
b = the beta coefficient
Km = the required rate of return on the market portfolio

Importance of CAPM:

 CAPM takes into account the stock market movement. So it correctly reflects the changes
in the market price of the shares.
 CAPM classifies the risk free return & risk oriented return, which helps an individual to
understand how much risk he bears.
 CAPM explains how to reduce risk & to increase return by selecting the best market
portfolio.

Limitations of CAPM:

 CAPM does not take into account the changes taking place in competition, economic
conditions, political conditions etc, which affects the company a lot.
 Beta measures systematic risk only. but investors are always interested in total risk. CAPM
approach needs lots of data, which is not available with the brokers & exchanges. So
difficult to give exact figures of risk taken by the investors.

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Portfolio standard deviation falls as the number of securities increases, but it cannot be reduced
to zero. The risk that remains even after extensive diversification is called market risk, risk that
is attributable to marketwide risk sources. Such risk is also called systematic risk, or
nondiversifiable risk .

In contrast, the risk that can be eliminated by diversification is called unique risk , firm-specific
risk , nonsystematic risk , or diversifiable risk .

On average, portfolio risk does fall with diversification, but the power of diversification to
reduce risk is limited by systematic or common sources of risk.

Portfolio analysis with the ratios :

The Sharpe ratio and the Treynor ratio (both named for their creators, William Sharpe and Jack
Treynor), are two ratios utilized to measure the risk-adjusted rate of return on either an
investment portfolio or an individual stock. They differ in their specific approaches to
evaluating investment performance.

1. Sharpe’s ratio = (Rm-Rf)/SD of portfolio

The Sharpe ratio aims to reveal how well an equity investment portfolio performs as compared
to a risk-free investment. The common benchmark used to represent a risk-free investment is
Treasury bills or bonds. The Sharpe ratio calculates either the expected or the actual return on
investment for an investment portfolio (or even an individual equity investment), subtracts the
risk-free investment's return on investment, and then divides that number by the standard
deviation for the investment portfolio.

The primary purpose of the Sharpe ratio is to determine whether you are making a significantly
greater return on your investment in exchange for accepting the additional risk inherent in
equity investing as compared to investing in risk-free instruments.

2. Treynor’s ratio = (Rm-Rf)/Beta of portfolio

The Treynor ratio also seeks to evaluate the risk-adjusted return of an investment portfolio, but
it measures the portfolio's performance against a different benchmark. Rather than measuring a
portfolio's return only against the rate of return for a risk-free investment, the Treynor ratio
looks to examine how well a portfolio outperforms the equity market as a whole. It does this by
substituting beta for standard deviation in the Sharpe ratio equation, with beta defined as the
rate of return that is due to overall market performance. For example, if a standard
stock market index shows a 10% rate of return, that constitutes beta; an investment portfolio

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showing a 13% rate of return is then, by the Treynor ratio, only given credit for the extra 3%
return that it generated over and above the market's overall performance. The Treynor ratio can
be viewed as determining whether your investment portfolio is significantly outperforming the
market's average gains.

3. Jenson’s ratio = also known as Jenson’s alpha (α)

alpha = Ri – [Rf + b(Rm-Rf)]

where Ri = return on fund, b = beta of fund

If alpha is positive, the fund has performed better than enough return compensated for the risk
taken by fund.

TOTAL RISK = TOTAL VARIANCE= SYSTEMATIC VARIANCE + UNSYSTEMATIC VARIANCE

σ² = β²σ²m + σi²

SYSTEMATIC VARIANCE = BETA SQUARE

UNSYSTEMATIC RISK = TOTAL RISK - SYSTEMATIC VARIANCE

 COEFFICIENT OF DETERMINATION EXPLAINS

THE PROPORTION OF RISK WHICH IS MARKET RELATED SO IT IS SYSTEMATIC RISK

WHERE AS REMAINING RISK IS COMPANY SPECIFIC,

WHICH MEANS NON-SYSTEMATIC OR FIRM SPECIFIC RISK

 R SQUARE = SHOWS RETURN ON STOCK IS EXPLAINED BY RETURN ON MARKET

LOWER R SQUARE MEANS BETA IS A POOR INDICATOR OF STOCK PERFORMANCE

MARKOWIZ EFFICIENT PORTFOLIO

Minimum Variance Portfolio

X1 = [(σ2)² - (r12)(σ1)(σ2)] / (σ1)²+ (σ2)²- 2(r12)(σ1)(σ2)

Stocks bonds
E(R) 12% 6%
Std dev 15% 10%
Correlation coefficient 0.10

Put in above formula, answer is : W1 = 28.8136%

Same formula can be written in covariance form :

X 1 = [(σ2)² - Cov12] / (σ1)²+ (σ2)²- 2Cov12

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Relationship between real rate & nominal rate

(1 + rr)(1 + i) = (I + rn)
Where i = inflation, rr=real rate, rn=nominal rate

Annualised return Vs EAR = effective annual rate

E.g., If 6 months return on stock is 8%, then annualised return will be 8%x (12/6)= 16%
But EAR = (1+0.08)² - 1 = 16.64%

MCQs

 Investors prefer diversified companies because it helps in reducing risk & not because
they are less risky
 If stocks are perfectly correlated, diversification will not reduce risk.
 Risk will be minimum when two stocks have perfect negative correlation.
 When beta is 2, it means that your portfolio is twice as risky as market portfolio.
 But it does not mean that you have good or bad portfolio.
 For a well-diversified portfolio , only market risk matters
 Risk averse investors prefer portfolio with beta less than 1

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