SECURITY ANALYSIS

&
PORTFOLIO MANAGEMENT

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 Portfolio Expected return (Rp) % Risk
A 17 13
Risk (
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 the
feasible region.
• Efficient frontier, as “ a line created from
the risk-reward graph, comprised of
optimal portfolios”

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 The notion of "optimal" portfolio can be
defined as
• For any level of market risk (volatility)
consider all the portfolios, which have that
volatility. From among them all, select the
one, which has the highest expected
return.
• 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 risk

and return for an efficient portfolio?
• What is the relationship between risk
and return for an individual security?

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 Assumptions of CAPM
• An individual seller or buyer cannot affect the price
of the stock
• Investors make their decisions only on the basis of
the expected returns, standard deviations and the
covariance of all pairs of securities.
• Investors are assumed to have homogenous
expectations during the decision-making period.
• The investor can lend or borrow any amount of
funds at the riskiless rate of interest.
• Assets are infinitely divisible.
• There is no transaction cost, i.e. no cost involved
in 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 that
determine the CAPM line:

• Risk free rate: Risk free rate is the return on the security that
is free from default risk and is unrelated with returns from
anything else in the economy.
• Market risk premium: The risk premium used in the CAPM is
typically based on historical data. It is calculated as the
difference between the average return on stocks and the
average risk-free rate
• Beta: The beta of an investment is the slope of the following
regression relationship:
Rit = i +βi 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 of
riskless and risky asset. The “S” portfolio does not
represent any riskless asset but the line Rf S gives the
combination of both. The portfolio along the path Rf S is
called lending portfolio, which is some money is invested
in the riskless asset or may be deposited in the bank for
a fixed rate of interest. If crosses the point S, it becomes
borrowing portfolio. Money is borrowed and invested in
the risky asset. The straight line is called capital market
line (CML). It gives the desirable set of investment
opportunities between risk free and risky investments.
The CML represents linear relationship between the
required rates of return for efficient portfolios and their
standard deviations.

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 • E(Rp) = Rf + Rm -Rf *p
• m

•E(Rp) = portfolio’s expected rate of

return
•Rm = expected return on market
portfolio
•m = standard deviation of market
portfolio
•p = 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 a
standard deviation of return of 25 per
cent. Under equilibrium condition as
described by CAPM, what would be the
expected return for a portfolio having no
unsystematic risk and 20 percent
standard deviation of return?

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