Security Portfolio Analysis

8/14/2019 Security Portfolio Analysis

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SECURITY ANALYSIS

&PORTFOLIO MANAGEMENT

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Risk (

Portfolio Expected return (Rp) % Risk

A 17 13

B 15 8

C 10 3

D 7 2

E 7 4

F 7 8

G 10 12

H 9 8

J 6 7.5



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FEASIBLE REGION



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EFFICIENT REGION



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Some Definitions

The collection of all possible portfolio

options represented by the broken-egg

shaped region is referred to as thefeasible region.

Efficient frontier, as a line created fromthe risk-reward graph, comprised of

optimal portfolios



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The notion of "optimal" portfolio can bedefined as

For any level of market risk (volatility)consider all the portfolios, which have that

volatility. From among them all, select theone, which has the highest expectedreturn.

For any expected return, consider all the

portfolios which have that expected return.From among them all, select the one,which has the lowest volatility.



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The Capital Asset Pricing Model

(CAPM)The Capital Asset pricing Model (CAPM)

developed by William Sharpe, is

concerned with two key questions:

What is the relationship between riskand return for an efficient portfolio?

What is the relationship between riskand return for an individual security?



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Assumptions of CAPM

An individual seller or buyer cannot affect the priceof the stock

Investors make their decisions only on the basis ofthe expected returns, standard deviations and thecovariance of all pairs of securities.

Investors are assumed to have homogenousexpectations during the decision-making period.

The investor can lend or borrow any amount offunds at the riskiless rate of interest.

Assets are infinitely divisible.

There is no transaction cost, i.e. no cost involvedin buying and selling of stocks.

There is no personal income tax.

Unlimited quantum of short sales, is allowed.



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CAPM Cont.

To apply CAPM, you need to estimate the following factors thatdetermine the CAPM line:

Risk free rate: Risk free rate is the return on the security thatis free from default risk and is unrelated with returns fromanything else in the economy.

Market risk premium: The risk premium used in the CAPM istypically based on historical data. It is calculated as thedifference between the average return on stocks and theaverage risk-free rate

Beta: The beta of an investment is the slope of the followingregression relationship:Rit = i +i RMT +eit

where: return on investment I return on the market portfolio intercept of the linear regression relationship between RMT

and Rit



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Capital Market Line?

The line RfS represents the all-possible combination ofriskless and risky asset. The S portfolio does notrepresent any riskless asset but the line Rf S gives thecombination of both. The portfolio along the path Rf S is

called lending portfolio, which is some money is investedin the riskless asset or may be deposited in the bank fora fixed rate of interest. If crosses the point S, it becomesborrowing portfolio. Money is borrowed and invested inthe risky asset. The straight line is called capital market

line (CML). It gives the desirable set of investmentopportunities between risk free and risky investments.The CML represents linear relationship between therequired rates of return for efficient portfolios and theirstandard deviations.



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E(Rp) = Rf + Rm -Rf * p

m

E(Rp) = portfolios expected rate ofreturnRm = expected return on marketportfoliom = standard deviation of market

portfoliop = standard deviation of the portfolio



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Exercise

Assume that the risk free rate of return is 7

per cent. The market portfolio has an

expected return of 14 per cent and astandard deviation of return of 25 per

cent. Under equilibrium condition asdescribed by CAPM, what would be the

expected return for a portfolio having nounsystematic risk and 20 percentstandard deviation of return?


Security Portfolio Analysis

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