Optimal Portfolio Selection

Return
Return : It is the primary motivating forces that drives investment.  It represents the reward for undertaking the investment. In security analysis we are primarily and particularly concerned with returns from investors perspective.  The return of an investment consists two components : (i) Current return (ii) Capital return. (i) Current return: Periodic cash flow (income) such as return: dividend and interest. This can be zero or positive. (ii) Capital return: The price appreciation or price changes. return: This can be zero, positive and negative also. Thus Total Return = Current return + Capital return

Historical (ex-post) Return (ex Historical capital return excluding Dividend. Period : 0 1 2 3 4 Price : 100 110 108 130 115 Solution: R1 = (P1-P0)/P0 =(110 -100)/100 =0.10=10%

 Historical capital return including Dividend. Period : 0 1 2 3 4 Price : 100 110 108 130 115 Dividend: 5 7 8 3 Solution:R1 = [(P1-P0)+D1]/P0 =[(110 -100)+5]/100 =0.15=15% This return will give the investors an insight or the prediction about the future return.

Historical ( ex-post) Risk ex The majority of investors tend to emphasize the return. They also tend to view the risk in subjective as well as comparative term. Suppose you are evaluating two shares A & B for investment. You have collected data of return earned for the last 5 years. Stock A: 30% 28% 34% 32% 31% Stock B: 26% 13% 48% 11% 57% You have to choose one stock among these two.

In this context , we interpret risk essentially in the terms of the variability of the security return. The most common measures of risk ness of security is SD and Variance of return. Given below returns of two stocks X and Y.
Period Return of stock X(%) Return of stockY(%) stockY(%)

1 -6 2 3 3 10 4 13 5 16 Calculate which stock is more risky ?

4 6 11 15 19

Period 1 2 3 4 5 Sum

X -6 3 10 13 16 36

Y 4 6 11 15 19 55

(X X) -13.2 -4.2 2.8 5.8 8.8

(Y Y) (X X)2 -7 -5 0 4 8 174.24 17.64 7.84 33.64 77.44 310.84

(Y Y)2 49 25 0 16 64 154

Mean of X = 36/5 = 7.2 =X Mean of Y = 55/5 =11=Y Variance of X = (X- X)2/(n -1)= 310.80/(5-1)= 77.7 and the S.D (X310.80/(5=77.7=8.815

Measuring Expected (ex-ante) Return (exWhen we invest in a stock we try to anticipate the future streams return based on the past performance of the stock. It may be -5%, 15% or 35%. Further the likely hood of these possible returns can vary. Hence we should think in terms of probability distribution. The probability of an events represents the likelihood of its occurrence. For example there is a 70% chance that the price of the stock will increase and 30% chance that the price of the stock will not increase during the next quarter .

Economic scenario Boom Stagnation Recession

Probability of occurrence 0.25 0.50 0.25

Return from stock A(%) 36 26 12

The expected return would be E(R) = (0.25*36)+(0.50*26)+(0.25*12) = 25% The risk of the stock : 2 =P *[R E(R)]2 i *[Ri =(36=(36-25)2 0.25 + (26-25)2 0.50 + (12-25)2 (26(120.25 = 73% SD = 8.54%

Reduction of risk through Diversification

Investment Analysis: Measuring risk & return. Portfolio Mgt: minimize risk or maximize return. Mgt: Example: Concept of Covariance: the degree to which the return of two securities vary or change together. Concept of Correlation: the degree of relationship between two variables.

Portfolio Risk & Return

The performance of the three stocks A, B and C for the four years are given below. Compute the average return, variance and S.D.
Period 1 2 3 4 A(%) 10 12 14 16 B(%) 11 9 13 17 C(%) 8 12 9 15

_ (A A) -3 -1 1 3

_ (B B) - 1.5 - 3.5 0.5 4.5

_ (C C) -3 1 -2 4

12 4.5 3.5 0.5 13.5

13 9 -1 -2 12

23 4.5 - 3.5 -1 18

Covab =22/n-1 =7.3 =22/nCovac = 6 Covbc = 6

WA=50%, WB=20%, W C =30% _ _ _ Return of the portfolio = A WA + B WB +C Wc =12.3% Variance of portfolio( 2) = 2A W2A + 2B W2 B + 2 W2 + 2[ Cov C AB WA W B + CovBC WB C W C + CovAC WA W C ] = 7.02% S.D. = 2.65%

Economic scenario Boom Stagnation Recession

Probability of occurrence 0.40 0.35 0.25

A(%) 15 12 8

B(%) 11 13 14

C(%) 13 9 6

The expected return would be E(A) = (0.40*15)+(0.35*12)+(0.25*8) = 12.2% SD(A) = 2.75% E(B) = 12.45% SD (B) = 1.24% E(C) = 9.85% SD(C) = 2.82%

A-E(A) 2.8 - 0.2 - 4.2 COV

B-E(B) -1.45 0.55 1.55

C-E(C) 3.15 - 0.85 - 3.85

12P 2 P - 1.62 - 0.04 -1.63 -3.29

23P 3 P - 1.83 -0.16 -1.49 -3.48

12P 2 P 3.53 0.06 4.04 7.63

Portfolio Return = ? Portfolio Risk = ?

Decomposition of Risk
Systematic risk : This risk refers to that portion of total variability of return caused by the factors affecting the price of all securities. This risk affects the market as a whole. The economic conditions, political situations and the sociological changes affect the security market. Example : A steep increase in the international oil prices is almost certain to affect the entire market adversely. Unsystematic risk : This risk is the portion of total risk that is unique to a firm or industry. This risk is also called diversifiable risk. Cont

Example : managerial inefficiency, technological changes, availability of raw materials, change in customer preferences, labor strikes, unexpected entry of new competitor. The nature and magnitude differ from industry to industry and company to company.

Systematic risk
Market risk : It refers to the investors attitude towards the market. The basis for this reaction is a set if real tangible events political, social or economic. Interest rate risk : This risk refers to the uncertainty of future market values and the size of the future income caused by fluctuation in the general level of interest rate. Purchasing power risk : the value of currency decreased & hence less surplus money to invest in the market.

Unsystematic risk
Business risk : This risk caused by the operating
environments of the business. This risk can be divided into two broad categories - external and internal business risk. (i) Internal business risk is largely associated with the efficiency with which a firm conducts its operations within the broad operating environment. (ii) External business risk is result of operating conditions imposed upon the firm by circumstances beyond its control.

Financial risk : This risk associated with the way in which a

company finance its activities. We usually gauge financial risk by looking at the capital structure of the firm.

Beta

Beta Estimation
The following Table gives the rate of return of X Ltd. and the market over a period of time. Calculate beta of X Ltd.
Month January February March April May June Return of X Ltd. 23% -14% 18% -9% 16% 7% Market return 21% -12% 13% -11% -19% 5%

The characteristic line is the regression line of best fit through a scatter plot of rate of return for the individual risky asset and for the market portfolio of risky assets over some designated past period.

Three Key Decisions

(i) The length of estimation period (ii) The return interval (iii) The choice of market index.

Fundamental Determinants
(i) The type of business (ii) Degree of Operating Leverage (iii) Degree of Financial Leverage

Beta Smoothing:

Portfolio Beta:
Company Infosys ICICI Ranbaxy TISCO GACL Portfolio Beta Beta 1.37 0.99 0.91 1.19 0.95 Proportion Weighted Beta 35% 20% 20% 10% 15% 100% 0.4795 0.1980 0.1820 0.1190 0.1425 1.2110

Capital Asset Pricing Model

CAPM: It is an equation that express the equilibrium relationship between securities required return & its systematic risk or beta. RA = Rf + Beta (Rm Rf) (R Expected rate of return: It is the rate of return from an asset that investors anticipate or expect to earn over some future time. Required rate of return: It is the minimum rate of return needed to induce to purchase a security.

Alpha
Mathematically this is the difference between the expected return & the required rate return from a security or a portfolio. A high positive alpha indicates that the security is undervalued & vice versa. Investors invest in a stock having higher alpha given the beta level of the stock suits their risk appetite.

Condition Recession & High Interest Recession & Low Interest Boom & High Interest Boom & Low Interest

Prob 0.20 0.15 0.40 0.25

HPCL - 13% 16% 32% 12%

BPCL - 4% - 2% 21% 20%

BSE 200 - 9% 8% 16% 20%

The Risk free rate of return is 4% . Which stock should we select?

Security Market Line

The SML represents the average or normal trade off between risk and return for a group of securities, where the risk is measured typically in terms of the security beta. So, we can say it is the graphical representation of the CAPM model. Application of SML :

o Large positive alpha indicates above normal performance and negative alpha indicate below normal performance. o If the alpha of a stock is positive we can conclude that the stock is underpriced and indication of buying signal and vice versa. o This measure we can also apply in measuring the performance of a portfolio. o Drawbacks : (i) beta depends upon the index (ii) Predicting performance of the portfolio managers.

Estimation of Risk Premium

(i) Large investors can be surveyed about their future expectations. (ii) The average actual premium earned over the past period. (iii) Implied premium extracted from current market data. The most common approach is the second one. The premium is computed to be the difference between average return on stocks and average return on risk free securities over the extended period of history.

Major issues
(i) Time period used (ii) Arithmetic Average Vs. Geometric Average (iii) Risk free rate (T-bill Vs. T-Bond /G-Sec). (TT/G-

Equity Risk Premium in US

T-Bill AM 1928-2004 1964-2004 1994-2004 7.92% 5.82% 8.60% GM 6.53% 4.34% 5.82% AM 6.02% 4.59% 6.85% T-Bond GM 4.84% 3.47% 4.51%

Equity Risk Premium in India

AM 1979-1991 1991-2008 1979-2008 15.34% 12.83% 12.79% GM 11.87% 6.52% 9.75%

Reference: J.R. Varma & S Barua; IIMA Working Paper. They use Sensex as a proxy of market return and short term G-sec rate as a proxy of risk free rate of return.

Risk Aversion & Utility Value

One would rank each portfolio as more attractive when the expected return is higher and lower when risk is high. How can investor quantify the rate at which they are willing to trade-off risk & return? trade We will assume that each investor can assign a utility score to competing investment portfolios based on expected risk & return. Portfolio receives high utility scores for high expected return and lower score for high volatility.

U = E(r) A 2 Where, U = Utility Value E(r) = Expected return of the portfolio 2= Variance of portfolio returns A = An index of investors risk aversion. A = 0 for risk neutral investors A < 0 for risk lovers A > 0 for risk averse

Utility scores of alternative portfolios for investors with varying degrees of risk aversion
Investors Risk Aversion (A) 2.0 3.5 5.0 Portfolio L E(r) = 0.07, = 0.05 0.07-1/2 20.052=0.0675 =0.0656 =0.0638 Portfolio M Portfolio H E(r) = 0.09, = 0.10 E(r) = 0.13, = 0.20 = 0.080 =0.0725 =0.065 =0.09 =0.06 =0.03

The portfolio lies with the highest utility scores that would be assigned by each investors appears in bold. High risk portfolio would be chosen by the investors with the lowest degree of risk aversion A = 2.

Indifference Curve [A=4]

Expected Return 0.10 0.15 0.20 0.25 S.D. 0.200 0.255 0.300 0.339 Utility 0.10 0.5 40.2002=0.02 0.02 0.02 0.02

These equally preferred portfolios lie in the mean-S.D. plane on a curve called the indifference curve that connects all the portfolio points with same utility.

Capital Market Theory

Markowitz Efficient Frontier. Covariance & Correlation of risk free asset with risky asset. Combination of risky assets with risk free asset. Risk return possibilities with leverage. Lending & borrowing at risk free rate. Dominant portfolio The Separation Theorem.

Markowitz Efficient Frontier

Using this model an investor can identify a set of portfolios that maximize expected returns at each level of risk. A set of efficient portfolios thus obtained. A portfolio is said to be an efficient portfolio, if it offers the maximum expected return for a given level of risk or the minimum risk for a given level of expected return.

Portfolio of one risky asset & a risk free asset

Suppose the investment budget, Y, to be allocated to risky portfolio P, the remaining (1-Y) is to be (1invested in the risk free asset F. The base rate of return for any portfolio is the risk free rate plus the risk premium multiplied with proportion of risky assets. When we combined a risky asset & a risk free asset in a portfolio, the S.D. of the portfolio would be the S.D. of the risky asset multiplied by the weightage of the risky asset in the portfolio.

Risk tolerance & asset allocation

Individual investors have different risk aversion. Given an identical opportunity set (risky & risk free securities) different investor will choose different position in the risky asset. In particular the more risk averse investors will choose to hold less of the risky asset & more risk free asset. Investors attempts to maximize utility by choosing the best allocation to the risky asset.

Utility level for various position of risky asset for an investor with risk aversion A=4
Y E(Rc)
0 0.07 0.1 0.078 0.2 0.086 0.3 0.094 0.4 0.102 0.5 0.110 0.6 0.118 0.7 0.126 0.8 0.134 0.9 0.142 1.00 0.150
c

Utility
0.07 0.077 0.0821 0.0853 0.0865 0.0858 0.0832 0.0736 0.0720 0.0636 0.0532

0.00 0.022 0.044 0.066 0.088 0.110 0.132 0.154 0.176 0.198 0.220