Corporate Finance

Section-F, Group-6

Corporate Finance- 1
Efficient Frontier for a Portfolio HCL, IOCL, PNB, Emami

Submitted to
Prof. S.K.Ganguli

Submitted by
Section F Group 6 ATUL GARG (11FN-126) DEEPSHIKHA AGARWAL (11FN-033) NIRAJ SATNALIKA (11IB-038) RAHUL KUMAR (11DM-118) RAVI RANBIR (11DM-123) SAHIL GOEL (11DM-131)

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Corporate Finance

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Objective:To track a multi-share portfolio consisting of four stocks traded on the open market: 1. HCL Technologies (BSE: 532281 | HCLTECH) 2. Indian Oil Corporation Limited ((BSE: 530965 l IOCL) 3. Punjab National Bank (BSE :532461 l PNB ) 4. EMAMI Ltd. (BSE:531162 l EMAMI LTD) And chart their two year-by-year returns, calculate the returns, variance and standard deviations along with the covariance between them and thus plot the efficient frontier for the portfolio.

Companies at a glance:
1. HCL Technologies is a leading global IT services company, working with clients in the areas that impact and redefine the core of their businesses. Since its inception into the global landscape after its IPO in 1999, HCL focuses on 'transformational outsourcing', underlined by innovation and value creation, and offers integrated portfolio of services including software-led IT solutions, remote infrastructure management, engineering and R&D services and BPO. 2. Indian Oil Corporation limited:- Indian Oil Corporation Ltd. is India's largest company by sales with a turnover of Rs. 3,28,744 crore ($ 72,125 million) and profit of Rs. 7445 crore ($ 1,633 million) for the year 2010-11. Indian Oil is the highest ranked Indian company in the latest Fortune Global 500 listings, ranked at the 98th position. Indian Oils vision is driven by a group of dynamic leaders who have made it a name to reckon with. 3. Punjab National Bank:- Since its humble beginning in 1895 with the distinction of being the first Swadeshi Bank to have been started with Indian capital, PNB has achieved significant growth in business which at the end of March 2011 amounted to Rs 5,55,005 crore. PNB is ranked as the 2nd largest bank in the country after SBI in terms of branch network, business and many other parameters. 4. Emami Group, a conglomerate born out of Bengal has a pan India presence through its battery of brands and business initiatives that blossomed under the parentage of Mr. R S Agarwal and Mr. R S Goenka since 1974. With an aggregate group turnover of about Rs 3700 crore the group has business interests in FMCG (fast moving consumer goods), paper , writing instruments, edible oil and cultivation, bio-diesel, hospitals, contemporary art, pharmacy, cement, real estate and retail. The Groups fountain of strength are its ingrained value system, innovativeness and an over 20,000 passionate and dedicated staff, engaged in knowledge sharing.

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Corporate Finance

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Emami Limited, the flagship company of the Group, is a coveted Rs 1300 crore business entity , a leading player in the personal and healthcare consumer products industry in India engaged in manufacturing and marketing of health, beauty and personal care products that are based entirely on ayurvedic formulation. Emami Limited has over 30 brands under its portfolio. The focus is on providing the consumers with innovative products which are capable of meeting their multiple needs and add value by enhancing the quality of day-to-day life.

Returns:

- Return is the ratio of money gained or lost (whether realized or unrealized) on

an investment relative to the amount of money invested. The Expected Return on a Portfolio is computed as the weighted average of the expected returns on the stocks which comprise the portfolio. The weights reflect the proportion of the portfolio invested in the stocks. Mean returns attempt to quantify the relationship between the risk of a portfolio of securities and its return. It assumes that while investors have different risk tolerances, rational investors will always seek the maximum rate of return for every level of acceptable risk. It is the mean, or expected, return that investors try to maximize at each level of risk.

Variance of a stock:- Variance measures the variability (volatility) from an average. Volatility
is a measure of risk, so this statistic can help determine the risk an investor might take on when purchasing a specific security. Variance is a mathematical expectation of the average squared deviations from the mean. Mathematically:- Let the return on a security for n periods be given by Ri where i = 1 to n then

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and

indicates the dispersion of returns, some dispersion may be The deviation negative while others may be positive to nullify their effect we use the squared deviations.

Standard Deviation of the stock:- Standard deviation is applied to the annual rate of
return of an investment to measure the investment's volatility For example, a volatile stock will have a high standard deviation while the deviation of a stable blue chip stock will be lower. A large dispersion tells us how much the return on the fund is deviating from the expected normal return. Mathematically, Standard deviation is the square root of the variance..

Covariance between two stocks:Covariance is a measure of the degree to which returns on two risky assets move in tandem. A positive covariance means that asset returns move together. A negative covariance means returns move inversely. One method of calculating covariance is by looking at return surprises (deviations from expected return) in each scenario. Another method is to multiply the correlation between the two variables by the standard deviation of each variable.

For example, if stock A's return is high whenever stock B's return is high and the same can be said for low returns, then these stocks are said to have a positive covariance. If an investor wants a portfolio whose assets have diversified earnings, he or she should pick financial assets that have low covariance to each other. Mathematically,

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Corporate Finance

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Correlation between stocks:Correlation between two stocks is used as a statistical measure of how two securities move in relation to each other. Correlation is computed into what is known as the correlation coefficient, which ranges between -1 and +1. Perfect positive correlation (a correlation coefficient of +1) implies that as one security moves, either up or down, the other security will move in lockstep, in the same direction. Alternatively, perfect negative correlation means that if one security moves in either direction the security that is perfectly negatively correlated will move in the opposite direction. If the correlation is 0, the movements of the securities are said to have no correlation; they are completely random. Mathematically,

Portfolio of stocks:A grouping of financial assets such as stocks, bonds and cash equivalents, as well as their mutual, exchange-traded and closed-fund counterparts. Prudence suggests that investors should construct an investment portfolio in accordance with risk tolerance and investing objectives. For example, a conservative or a risk-averse investor might favour a portfolio with large cap value stocks, broad-based market index funds, investment-grade bonds and a position in liquid, high-grade cash equivalents. In contrast, a risk loving investor might add some small cap growth stocks to an aggressive, large cap growth stock position, assume some high-yield bond exposure, and look to real estate, international and alternative investment opportunities for his or her portfolio.

Expected returns on a portfolio:The average of a probability distribution of possible returns, calculated by using the following formula: Where, Xi is the weight of Stock i, with a return Ri. For example, if a given investment had a 50% chance of earning a 10% return, a 25% chance of earning 20% and a 25% chance of earning -10%, the expected return would be equal to 7.5% = (0.5) (0.1) + (0.25) (0.2) + (0.25) (-0.1) = 0.075 = 7.5%

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Corporate Finance

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Although this is what one expects the return to be, there is no guarantee that it will be the actual return.

Variance of a portfolio:The measurement of how the actual returns of a group of securities making up a portfolio fluctuate. Portfolio variance looks at the standard deviation of each security in the portfolio as well as how those individual securities correlate with the others in the portfolio. Generally, the lower the correlation between securities in a portfolio, the lower the portfolio variance. Portfolio variance is calculated by multiplying the squared weight of each security by its corresponding variance and adding two times the weighted average weight multiplied by the covariance of all individual security pairs. Modern portfolio theory says that portfolio variance can be reduced by choosing asset classes with a low or negative correlation, such as stocks and bonds. This type of diversification is used to reduce risk. Mathematically;

Also,

Standard Deviation of a portfolio:The Standard deviation of a portfolio is given by the following formula: The standard deviation of a portfolios return is equal to the weighted average of the standard deviations of the individual returns when . As long as , the standard deviation of a portfolio of securities is less than the weighted average of the individual securities, i.e. the diversification effect applies as long as there is less than perfect correlation between the securities.

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Corporate Finance

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Portfolio
Overview The Expected return for the individual stocks can also be tabulated as follows: Company HCL IOCL PNB EMAMI Expected returns in % 36.78 -6.32 31.63 19.16

Variance and Covariance of the four securities can be tabulated as follows: HCL Technologies 9824.211 -1184.582 5708.158 6722.993 IOCL -1184.582 278.819 -598.035 -711.326 PNB 5708.158 -598.035 3496.181 4355.081 EMAMI 6722.993 -711.326 4355.081 7971.142

HCL Technologies IOCL PNB EMAMI

Calculations:Expected Returns The expected return for the portfolio can now be given by:

Let there be a weight of 0.25 assigned to all the four securities then the expected return will be given by:-

= .205 or 20.5%

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Corporate Finance

Section-F, Group-6

Efficient Frontier:-

Efficient Frontier:- The hyperbola is sometimes referred to as the 'Markowitz Bullet', and is the efficient frontier if no risk-free asset is available. With a risk-free asset, the straight line is the efficient frontier. A portfolio lying on the efficient frontier represents the combination offering the best possible expected return for given risk level.

Interpretation: - By using the obtained frontier we can find out the efficient frontier. This
will help in obtaining the optimal portfolios for different risk-averse and risk-taking investors. We can also figure out the minimum variance portfolio and corresponding weightage and its returns.

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Corporate Finance

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References:
Reference Text: Corporate Finance (8th Edition) by Ross, Westerfield, Jaffe and Kakani Online Resources: www.moneycotrol.com www.investopedia.com www.bseindia.com www.wikipedia.com

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