Security Analysis and Portfolio Mgmnt

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MARKOWITZPORTFOLIOTHEORY


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IntroductionIntroduction

The basic portfolio model was developed by Harry Markowitz(1952, 1959), who derived the expected rate of return for a

portfolio of assets and expected risk measure.

He showed that variance of the rate of return was a meaningfulmeasure of portfolio under a set of reasonable assumptions.

He derived the formula for computing the variance of a

portfolio.

This indicated the importance of diversifying investments toreduce the total risk of a portfolio and also how to diversify.


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AssumptionsAssumptions

Investors consider each investment alternative as beingrepresented by a probability distribution of expected returnsover some holding period.

Investors maximise one-period expected utility, and theirutility curve demonstrate diminshing marginal utility ofwealth.

Investors estimate the risk of the portfolio on the basis of thevariablilty of expected returns.


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AssumptionsAssumptions

Investors base decisions solely on expected return and risk, sotheir utility curves are a function of expected return and theexpected variance (or standard deviation) of returns only.

For a given risk level, investors prefer higher returns to lowerreturns. Similarly, for a given level of expected return, preferless risk to more risk.


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Alternate measures of riskAlternate measures of risk

One of the best known meaures of risk is variance or standarddeviation of expected returns.

It is a statistical measure of the dispersion of returns aroundthe expected value whereby a larger variance or standarddeviation indicates greater dispersion.

The idea being that more dispersed the expected returns, thegreater is the uncertanity and risk regarding future expectedreturns.


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Another measure of risk is the range of returns

In this measure of risk, it is assumed that a larger range ofexpected returns, from the lowest to the highest expectedreturn, means greater uncertanity and risk regarding futureexpected returns.


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Although there are numerous potential measures of risk, mostlyvariance and standard deviation of returns is used because:

This measure is somewhat intuitive

It is correct and widely recognised risk measure

It has been used in most of the theoretical asset pricingmodels


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Calculation of Variance (StandardCalculation of Variance (Standard

Deviation) of Returns forDeviation) of Returns for

Individual InvestmentIndividual Investment

Variance = 2 = [Ri - E(Ri)]2 Pi

where, Ri = possible rate of return

E(Ri) = expected rate of return

Pi= probability of the possible rate of return R

i

Standard Deviation = = [Ri - E(Ri)]2 Pi


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Variance (Standard Deviation) ofVariance (Standard Deviation) of

Returns for PortfolioReturns for Portfolio

Covariance is a measure of the degree to which two variablesmove together relative to their individual mean values overtime.

In portfolio analysis, usually covariance of rate of return isconsidered rather than prices or some other variable.

A positive covariance means that the rate or return for twoinvestments tend to move in the same direction relative to theirindividual means during the same time period.


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CAPITAL MARKET

THEORY


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Development of Capitalmarket theory

Capital market theory is generalizedtheory of capital asset pricing underconditions of uncertainty from the

Markowitz portfolio theory.

Williams Sharpe (1964)

Lintner (1965) and Mossin (1966)


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Assumptions:

All investors are efficient investors

who want to target point on theefficient frontier.

Investors can borrow or lend money

at the risk free rate of return (RFR). All investors have homogeneous

expectations

All investors have the same one-period time horizon such as onemonth, six months, or one year.


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Risk Free Asset

As note assumptions of a risk freeassets in the economy is critical toasset pricing theory. Therefore thissections explains the meaning of arisk free assets and shows the effecton the risk and return measureswhen this risk free asset is combined

with a efficient portfolio


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Both the expected return and thestandard deviation of return for aportfolio are linear combinations.

Possible portfolio returns andrisks looks like a straight linebetween the two assets.


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Capital assets pricing model

CAPM is a model that indicates whatshould be the expected or requiredrates of return on risky assets. This

transition is important because ithelps to value an assets by providingan appropriate discount rate to use

in any valuation model.


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Security market line

SML visually represent therelationship between risk and theexpected or required rate of returnon an assets. SML together with

estimates for the return on risk freeassets and on the market portfolio,can generate expected or required

rates of return for any asset basedon its systematic risk.


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Multi-factor risk model


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In this model two general approacheshave been employed in the factoridentification process

Macroeconomic Factors

Microeconomic Factors


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Macroeconomic Factors

Factors that attempt to capturevariations in the assets cash flowsand investment returns

These factors are external andinfluences the share prices

Eg:

Changes in inflation rate

Changes in the GDP rate


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Burmeister,Roll and Rossanalysed 5 risk exposures

Confidence Risk: based on unanticipated changes ininvestors to take on investment risk

Time Horizon Risk: Unanticipated changes in investors

desired time to receive payouts

Inflation Risk: Based on a combination of unexpectedcomponents of short term and long term inflation rates

Business Cycle Risk: unanticpated changes in the levelof overall business activity

Market Timing Risk: A part of risk associated in thestock market index


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Microeconomic Factors

Microeconomic factors is also called as the Characteristic BasedApproach Proposed byFama and French in 1993

Rf is the risk-free return rate, and

Km is the return of the whole stock market.

The "three factor" is analogous to the classical but not equal toit, since there are now two additional factors to do some of the work.

SMB stands for "small (market capitalization) minus big" and HML for "high (book-to-price ratio) minus low"; they measure the

historic excess returns of small caps over big caps and of valuestocks over growth stocks.


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BARRA :A leading risk forcasting andinvestment consulting firm has definedvarious micro economic risk factors as

follows

Volatility Momentum

Size Trading activity Growth Earnings Yield Value Dividend yield Leverage


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Limitations

It is developed with little theoreticalguidance as to the true nature of the

risk return relationship

It is a Mathematical model and so

specialist can only use it


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Thank You

for your patience


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Functions of Stock Exchange


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Introduction

On any Stock Exchange, there are memberswho deal with client orders, institutionalorders and in line business. Some brokers

specialize in the new issues market andsome in badla financing. Some act asjobbers, making two way offers to buy andsell in selected shares. All members arepermitted to trade in the trading Ring.


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Each member is permitted to have authorizedassistants up to a maximum number as fixedby the Stock Exchange. The members do

trading on their own behalf of their clients.If the member acts as a broker, he is doing aretail business or purchase and sale

transactions for the customers.


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If a member is doing wholesale business,offering both purchase and sale prices (bid andoffers) to the other member brokers then he is

called a jobber. Both brokers and jobbers arean essential part of the stock marketoperations.


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Specified and Non-specified Groups

The listed securities of the companies areclassified into a specified group and non-specified group on the basis of certain criteria.

Those in the specified list should be fully paid-up equity shares listed already on the exchangefor at least three years on the cash list and the

companys paid-up equity capital should beabove Rs.10 crores.


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Customers orders

The investor can place an order by telegram,telephone, letter or in person. The order maybe for the purchase or sale of a specified

number of shares of a company at a specifiedrate or range of prices. The member broker is acustodian for the shares/ securities of his client

till they are sold or delivered.


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The order to buy or sell may be given for afixed price or at a maximum or minimum pricerange which is also called a limit order. Some

orders are at best or at the market price.The member broker has to execute the order atthe best obtainable price in the market on aspecified date.


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Trading Ring

Trading on the stock exchange is officiallydone in the trading ring for three hours from11.30 a.m. to 2.30 p.m. or 12 noon to 3 p.m.

under electronic trading hours are extendedfrom 10 a.m. to 4 p.m. from Monday toFriday. Trading before or after official hours is

called kerb trading. In the trading ring, space isprovided separately for specified or non-specified sections.


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The members or their authorized assistantshave to wear a badge or carry with themidentity cards given by the exchange to enter

the trading ring. They carry a sauda blockbook, or confirmation memos, duly authorizedby the exchange and carry a pen with them.


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Block book

Each page of the Sauda book or the Blockbook taken to the floor of the stock Exchangeshould be duly authorized by the stockExchange authorities. Under electronic trading

the computer software is designed to give allthe returns to be submitted to stock exchangeand the accounts to be maintained by the

broker himself.


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Contract Note

It is important to ensure that the contract noteis written up on the day of the deal and postedto the client. This is a proof that the contractwas executed on that day and not on any other

day since prices fluctuate everyday. Besides,under article 43 (b) or (bb) of schedule 1 of theIndian stamp Act, the broker must affix a

revenue stamp.


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Thank You


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Role and Functions of a

stock exchange


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Stock exchanges have always served a vitalrole in bringing buyers and sellers together.

Created jobs for workers and wealth forinvestors.

Stock exchanges also serve as the initial placefor companies to sell the shares of their

companies when they want to acquire capital. They also provide individuals the ability to

invest in companies.

Stock exchanges help companies raise money

to expand.

h k h k


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The stock exchange markethas multiple role, its main

activities are two:

To promote the savings.

To provide liquidity to the investors


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Function of the stockexchange: Raising capital for businesses . Mobilizing saving for investment .

Facilitating company growth .

Redistribution of wealth . Creating investment opportunity of small

investor.

Govt. capital- raising for development project

Barometer of the economy

Other functions of the stock


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Other functions of the stockexchange market as an

organization are: To guarantee the legal and economic security of theagreed contracts. To provide official information about the quantities

that are negotiated and of the quoted prices.

To fix the prices of the securities according to thefundamental law of the offer and the demand.

To establish purpose of assisting, regulating andcontrolling business of buying, selling and dealing insecurities.


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To provide market for the trading ofsecurities to individuals and organizations

seeking to invest their saving or excessfunds through the purchase of securities.

To provide physical location for buying andselling securities that have been listed for

trading on that exchange. To establish rules for fair trading practices

and regulates the trading activities of itsmembers according to those rules.

Functions done by the


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Functions done by thestock exchange market in

favour of the investor: It permits him the access to the profitableactivities of the big companies.

It permits for the investor to have a

political power in the companies in whichhe invests its savings due that theacquisition of ordinary shares gives him theright (among other things) to vote in the

general shareholders meetings of thecompany in question.


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It offers the possibility of diversifying

your portfolio by enlarging the fieldof strategy of investments due toalternative options, as could be the

derived market, the money market,etc.

It offers liquidity to the securityinvestments, through a place inwhich to sell or buy securities.

With respect to the


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With respect to thefunction done by the stock

exchange market in favorof the companies: It supplies them with the obtaining of long-term

funds that permits the company to makeprofitable activities or to do determine projects

that otherwise wouldnt be possible to developfor lack of financing. Also, this funding signifiesa less cost than if obtained at other channels.

The securities quoted at the stock exchange

market usually have more fiscal purposeadvantages for the companies.


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It offers to the companys freepublicity, which in other way wouldsuppose considerable expenses. The

institution is objecting of attention ofthe media (television, radio, etc.) incase any important change in its

owners (the share holders).

Security Analysis and Portfolio Mgmnt

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