Bhupesh Kumar (B18018)

Case Background
As a trainee portfolio manager, Isha Kapoor has been asked to build an investment portfolio. The
portfolio will have stocks of the firms listed on National Stock Exchange. Moreover, she needs to
cover various sector and pick one firm from each sector. All the sectors and name of the company
from the respective sector are presented in the next topics.

The way Isha Kapoor is proceeding is first gather historical data on the stocks that she has picked
up. This will help her get an idea how the different stocks have performed in the past. Based on
this she will be able to take an informed decision. She intends to cover data of 7 years.

For taking only the genuine data i.e. filtering out the effects of dividends and splits, she decides to
use the adjusted closing prices. With all the data now available she proceeds to analyse and extract
information which will help in building the portfolio.
 Bhupesh Kumar (B18018)

Five Critical Financial Problems

1. What are the different attributes that needs to be analysed and which way of analysis should
be used?
Using historical data, we can get the returns that safe investments such a G-secs gives and
investing in them is risk free. However, even though we can get returns for stocks using
historical data it’s not such a simple decision since a lot of risk is involved. Hence a thorough
study of data is done and various parameters are obtained which provides a basis of investment.
Few of these parameters are daily returns of course, standard deviation, variance and beta. Each
of the listed parameters have their own significance. While standard deviation and variance are
specific risk associated with a stock beta denotes the market risk. Based on the type of risk
associated we create the risk mitigation strategy. Beta is nothing but a measure of how the prices
of a particular stock moves in respect to the market. For this particular case we will be using
S&P CNX 500 index to calculate beta.
2. How can the sectors with least risks be identified?
As a portfolio manager it is our main aim to make a portfolio which can provided maximum
returns for a given risk profile. As mentioned earlier there are two types of risk associated and
our main focus is to reduce systematic risk. There can be a couple of factors that can be used to
identify sectors with least amount of risk. Some sectors such FMCG are traditionally considered
defensive and safe. Since, whatever be the market conditions the demand for FMCG goods
remains same. On the other hand firms in oil sector and considered very volatile. However, it
is expected that when one invests in a riskier stock he will get a higher return. Historical data
also helps us in selecting less risky sector. The stock which has less spread of possible returns
or less standard deviation will be less risky. Most of the times it is a trade-off between risk and
return.
3. Why should one diversify?
In the real world it will more often than not happen that a stock offers higher return but is more
risky. In such a scenario it is not binding to invest in one stock. One can take both the stock and
invest. The return will simply be the weighted average of the expected returns of the individual
stocks. But that’s not the reason why one invests in both. This is done with a purpose to reduce
 Bhupesh Kumar (B18018)

the portfolio risk. The standard deviation in this case will be less than the average of the risks
of the separate sectors. The formula is given by:
Standard Deviation = √𝑥12 𝜎12 + 𝑥22 𝜎22 + 2𝑥1𝑥2𝜎1𝜎2𝜌12
Where, x denotes the fraction of investment,
𝜎 denotes the standard deviation of individual stock
and, 𝜌 denotes correlation between the two stocks.
4. What all factors affect the diversification of a portfolio and what proportion of investment
should go in a particular sector or company in the portfolio?
As we have seen in the expression for standard deviation for the portfolio of two stocks
diversification depends on the fraction invested, standard deviation of individual stocks and the
correlation between the stocks. Here the expression is for only two stocks however, one can
have as many number of stocks one wants. However, in case there are many securities, the
variability of the portfolio will reflect only the covariance. For our own benefit we will always
want a negative correlation between stocks.
The proportion of investment that should go in a particular investment will essentially depend
upon the risk profile of the investor. If one is willing to take more risk he can choose to invest
more is such a stock and so on.
5. How should the obtained beta values be interpreted?
The other part of the risk, i.e. market risk, of a portfolio is a function of risks of individual
components. Beta value of a stock tells us how the stock moves corresponding to the market.
Stocks with beta more than one will provide more volatility than market while stocks with beta
between 0 and 1 will be fairly stable than the market. The market has a beta equal to 1. A
negative beta implies the stock moves in opposite direction as the market.
 Bhupesh Kumar (B18018)

Analysis and Interpretations

1. Calculation of daily returns, mean return, standard deviation and beta:

The first step towards calculating any of the attribute daily returns need to be calculated.
The data has been taken from yahoo finance. The formula used for calculating daily return
is:
𝑆𝑡𝑜𝑐𝑘 𝑃𝑟𝑖𝑐𝑒(𝑡)
Return = 𝑆𝑡𝑜𝑐𝑘 𝑃𝑟𝑖𝑐𝑒(𝑡−1) − 1

For percentage we multiply the above with 100.

The mean return can be calculated simply. Standard deviation gives us the spread of possible
rates. For calculating standard deviation it is assumed stock prices are normally distributed.
Standard deviation can also be calculated simply using the required function in the MS
Excel.
The standard formula for calculating beta is,
𝑐𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒
Beta (𝛽) = 𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒

Beta can also be understood as a plot of stock price with respect to the market index. The
best line that fits has a slope beta.
There are a total of 11 sectors that have been picked and as such 11 stocks have been
analysed.
All the above calculation provide us with following data.

Average
Beta Std. Dev
Daily Return
Tata Motors 0.1437% 0.4185 3.062%
HDFC 0.0895% 0.5358 2.092%
LT 0.0712% 0.5298 3.502%
TKK 0.2175% 0.3909 3.026%
Dabur 0.1056% 0.2798 1.898%
Sun Pharma 0.1518% 0.1313 2.074%
Wipro 0.1297% 0.6012 4.397%
Tata Steel 0.0079% 0.8078 3.035%
IOC 0.3274% 0.6869 10.784%
NTPC -0.0029% 0.4187 2.030%
Airtel 0.0125% 0.3192 2.435%
 Bhupesh Kumar (B18018)

Above data provides various insights about the selected stocks.

We observe IOC provides highest daily return however, at the same time it has highest
standard deviation. Which means it is the riskiest stock to invest in. On the other hand Dabur
is the safest stock to invest but at the same time provides lesser return. On the basis of beta,
Tata Steel is closest to market beta and Sun Pharma is having lowest beta.
If a portfolio is having two stocks Tata Motor and Sun Pharma and equal investment is
made in both then expected return would be,
0.5 x 0.1437% + 0.5 x 0.1518% = 0.1477%
The standard deviation will be 0.002% calculated as per the formula. Thus we see when the
correlation between the stocks is very small, 0.1918 in this case, the standard deviation for
the whole portfolio comes down.

Let’s take a look at another method of doing the above analysis. This can be done using
logarithmic returns. The formula used is,
log[𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒 (𝑡)]
Logarithmic return = log[𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒 (𝑡−1)]

All other steps remain identical and we get the following table.

Average
Daily Beta Std. Dev
Return
Tata Motors 0.0421% 0.4280 1.3248%
HDFC 0.0294% 0.5398 0.9059%
LT 0.0056% 0.5372 1.4750%
TKK 0.0749% 0.3948 1.2942%
Dabur 0.0381% 0.2860 0.8205%
Sun Pharma 0.0566% 0.1359 0.8940%
Wipro 0.0212% 0.5628 1.7080%
Tata Steel -0.0166% 0.8211 1.3209%
IOC 0.0159% 0.4883 3.0926%
NTPC -0.0102% 0.4251 0.8827%
Airtel -0.0074% 0.3252 1.0520%

As we can see except the beta value of the stock all other values have been changed by a
fairly large amount. The simple reason being the reduction due to logarithmic scale. The
reason behind beta value still remaining is simple the fact that it is nothing but a plot of
stock price vs the market price. When the beta is plotted on logarithmic returns both the axis
 Bhupesh Kumar (B18018)

would reduced accordingly and hence beta remains almost same. The nature of other data
have changed. While earlier IOC had the highest return, now as per logarithmic returns
TKK has the highest daily average return. However, the standard deviation still is highest
for IOC. Hence we can say the analysis doesn’t throw same kind of data.

2. Expected Return:
The expected return as per the CAPM is given by
Return = Risk Free Rate + 𝛽*(Market Return – Risk Free Rate) + Error
For calculation purpose we will ignore the error here.
Market Daily Average Return = 0.0256%
Risk Free Rate as per case = 3.17% annually or 0.00868% daily
We get expected return as follows:

Expected
Return(%)
Tata Motors 0.015764
HDFC 0.017748
LT 0.017647
TKK 0.015297
Dabur 0.013418
Sun Pharma 0.010906
Wipro 0.018854
Tata Steel 0.022349
IOC 0.020304
NTPC 0.015767
Airtel 0.014084
 Bhupesh Kumar (B18018)

Recommendation and Implementation

The historical data are many a time very good indication and help in investment strategy.
Strategies such as momentum and pairs trading rely on historical data. The analysis based
on historical data shows that while a stock might give higher returns it might also be very
risky. In such a scenario diversification is the best way to go. Hence, Isha Kapoor must
design her portfolio having various stocks. While the market risk is difficult to hedge non-
systematic risk must be reduced. Also one need not take all the stocks or only two stocks.
A decision must be based on sound logic and data obtained through analysis. The investment
in individual stocks of the portfolio is based on risk profile of the investor which must be
taken care by the portfolio manager.
Also we must not always go with the historical data. What happened in past might not get
reflected in future. Also beta value whatever was calculated on the basis of seven years data
might not have remained same always. Hence, Isha must look out for any such shifts. This
will provide a better estimate of expected return.