SUMMER INTERNSHIP PROJECT REPORT

RISK AND RETURN ANALYSIS

SUBMITTED TO : MR. SURJIT TRIPATHY CM RELIANCE MONEY LTD. CUTTACK SUBMITTED BY: BISWARANJAN BEURA CFT07_035 PGDM JAIPURIA INSTITUTE OF MANAGENEMT, LUCKNOW BATCH - 2007-09

Acknowledgement
The two-month internship at Reliance Money Ltd. has taught me a lot and hence I take this opportunity to acknowledge all the guidance and help that I have received. Firstly, I would like to thank Reliance Money Ltd. for providing me the opportunity to work on this project. I would like to thank my project guide Mr. Surjit Tripathy for helping me in learning the lessons of professional management. His able guidance and valuable inputs have helped me a lot in successfully completing this project. I would like to extend my gratitude to Mr. Subhasis Hota (CM), Mr. Subadha Mohanty (CMT), Mr. Ashis Sahoo (BDE) for providing support to complete my internship. I am thankful to our director Dr. S. Chakravarty and Faculty Members of Jaipuria Institute of Management, Lucknow for their valuable insights on the purpose of Summer Internship and guiding me from time to time to help observe the crucial processes taking place within the organization. This acknowledgement would not be completed without extending my thanks to my friends, who did their summer internship along with me at Reliance Money Ltd., who helped me clear any doubts that arose during my internship and for extending their support to me during my period of internship.

Executive Summary
Project Undertaken The project undertaken in my summer internship was to calculate the risk and return ratio of various enlisted companies by using there past data. My job was to using that data calculate or estimate there future performance. In this project I have taken securities enlisted in Sensex (sensitive index). For my second project I calculated all these things for portfolio managed by various fund managers in their respective mutual fund portfolios. The objective of this project was to make competitive analysis of various mutual fund scheme on the basis of securities performance and than find out overall performance of portfolio. Objective of Summer Internship The objective of my summer internship was to check risk and return factors attached to any securities while using various financial tools like CAPM, beta, alpha, standard deviation, efficient market hypothesis, efficient frontier, correlation matrices etc, and understanding the Risk management by calculating Value at Risk (VaR), Extreme loss margin, Mark to market Margin, Sharpe Ratio etc. My work was to collect company specific past performance data and after using tools and techniques suggest my customer for portfolio i.e. group of securities. Next phase of my project was regarding competitive analysis of mutual fund schemes. PROPOSED METHODOLOGY: Studied how stock market functions and some basics of Sensex benchmarking

Collecting relevant material from Internet and various other secondary sources. Such as news papers, daily reports of the Company, etc Observing daily movements of the scrip and learning by noting down significant points. Estimating each securities expected movement with overall market movement Design efficient portfolio using various tools like Correlation matrix, Sharpe ratio, etc. Calculate return over risk of the portfolio and determining efficient portfolio. Analyzing certain other investment instruments such as Mutual Funds, Govt. Bonds, etc. Observing and helping different departments in the organization and learning from them.

LIMITATIONS OF THE STUDY: The main limitation of this report is that the study of this report is limited to the Shares listed in N.S.E and B.S.E and few other well-known stocks. The process is highly system/application oriented, so there is high dependency on Information Technology to help in improving the application/ process.

COMPANY PROFILE
RELIANCE MONEY PRODUCTS
Reliance Money Ltd. is one of the leading sectors of Anil Dhirubhai Ambani group. It deals mainly with the Demat account opening.

What is Demat?
Demat means dematirialisation of money, i.e. through online and off-line trading. Earlier before these broking companies came into picture the people interested in share market trading and investments had to trade through the nearest stock exchange. But now its totally client convenience process in which the client had to just open a Demat account in a broking firm and can trade or invest according to his/her convenience whenever and wherever he/she wants.

Why RELIANCE MONEY LTD.?

Reliance Money Ltd. is like a glazing star under the vast business of Reliance

Capital Ltd. Reliance Money provides a comprehensive platform, offering an

investment avenue for a wide range of asset classes. Its endeavor is to change the way India transacts in financial markets and avails financial services. Reliance Money offers a single window facility, enabling you to access, amongst others, Equity, Equity & Commodity Derivatives, Offshore Investments, IPOs, Mutual Funds, Life Insurance and General Insurance products. Reliance Money is the most cost-effective, convenient and secure way to transact in a wide range of financial products and services.Reliance Money Ltd. provides the clients with the lowest brokerage charges and the minimum account opening fee.

What we offer

Cost-effective:

Pay a flat fee of just Rs. 500/- valid for 2 months or specified transactional value.

Convenience: broker/agent,

Go online, through your

Call & Trade or Kiosk. Security: Dynamic password - keeps the account extra secure. Widest product range:Equity, Commodities, Derivatives, Offshore, Mutual, Funds, IPOs, Insurance. Other value-adds: Live news from Dow Jones,

research, expert views, etc are available free and in real time.

The highlights of the offering are Cost-effective: The fee charged by the affiliates of Reliance Money, through whom the transactions can be placed, is among the lowest charged in the present scenario. As an introductory offer, pay a flat fee of just Rs. 500/- valid for 2 months or specified transactional value*. Illustrative table showing fee structure & validity limits.

Unutilised Delivery limit may be added to Non-delivery limit Convenience: You have the flexibility to access Reliance Money services in multiple ways: through the Internet, Transaction Kiosks, Call & Transact (phone) or seek assistance through our Business Partners. Security: Reliance Money provides secure access through an electronic token that flashes a unique security number every 32 seconds (and ensures that the number used for the earlier transaction is discarded). This number works as a third level password that keeps your account extra safe. Single window for multiple products: 1. Equity 2. Equity and commodity derivatives 3. Offshore investment 4. Mutual funds 5. Insurance 6. IPOs

3 in 1 integrated access: Reliance Money offers integrated access to your banking, trading and demat account. You can transact without the hassle of writing cheques.

Demat Account with Reliance Capital: Through Reliance Money, you get a hassle-free demat account with Reliance Capital. The Annual Maintenance Charge for the Demat Account is just Rs. 50/- per annum. Other Services: Through the portal www.reliancemoney.com, Reliance Money provides: Reliable research, including views of external experts with an enviable track record Live news from Reuters and Dow Jones CEOs' / experts' views on the economy and financial markets The Personal Finance section provides tools that help you plan your investments, retirement, tax, etc Analyse your risk profile through the Risk Analyser Get a suitable investment portfolio using the Asset Allocator.

Project Details
This report is the detail study of Risk Management, which includes statistical calculations of various stocks listed in NSE & BSE. I started my project by calculating BETA of various stocks including Nifty. BETA is a measure of risk and volatility in a particular stock its study can really help traders who want to take advantage of the volatility in the market. Then I learn the theory of CAPM. The Capital Asset Pricing Model (CAPM) relates the risk-return trade-off of individual assets to market returns. The Capital Asset Pricing Model (CAPM) is used in finance to determine theoretically appropriate required rate of return (and thus the price if expected cash flows can be estimated) of an asset. After that I calculated Value at Risk (VAR) and Risk Reward Ratio. VAR is a very important tool to know the maximum risk attach to a particular stock or an asset in a given period of time. And Risk Reward Ratio is a financial tool that is being used by all the asset management company prior to investment. It basically represents the amount of risk are you taking for a given amount of return. Then my project leads to designing efficient portfolio. Efficient portfolio is design by selecting securities that may perform well together in the times to come at minimum risk.

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THEORIES APPLIED DURING INTERNSHIP 1. BETA OF A STOCK Beta measures a stock's volatility, the degree to which its price fluctuates in relation to the overall market. In other words, it gives a sense of the stock's market risk compared to the greater market. Beta is used also to compare a stock's market risk to that of other stocks. Investment analysts use the Greek letter '' to represent beta. This measure is calculated using regression analysis. A beta of 1 indicates that the security's price tends to move with the market. A beta greater than 1 indicates that the security's price tends to be more volatile than the market, and a beta less than 1 means it tends to be less volatile than the market. Essentially, beta expresses the fundamental tradeoff between minimizing risk and maximizing return. Let's give an illustration. Say a company has a beta of 2. This means it is two times as volatile as the overall market. Let's say we expect the market to provide a return of 10% on an investment. We would expect the company to return 20%. On the other hand, if the market were to decline and provide a return of -6%, investors in that company could expect a return of -12% (a loss of 12%). If a stock had a beta of 0.5, we would expect it to be half as volatile as the market: a market return of 10% would mean a 5% gain for the company.

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Basic guide to various betas: Negative beta - A beta less than 0 - which would indicate an inverse relation to the market - is possible but highly unlikely. Some investors used to believe that gold and gold stocks should have negative betas because they tended to do better when the stock market declined, but this hasn't proved to be true over the long term. Beta of 0 - Basically, cash has a beta of 0. In other words, regardless of which way the market moves, the value of cash remains unchanged (given no inflation). Beta between 0 and 1 - Companies with volatilities lower than the market have a beta of less than 1 (but more than 0). As we mentioned earlier, many utilities fall in this range. Beta of 1 - A beta of 1 represents the volatility of the given index used to represent the overall market, against which other stocks and their betas are measured. The Nifty is such an index. If a stock has a beta of one, it will move the same amount and direction as the index. So, an index fund that mirrors the Nifty will have a beta close to 1. Beta greater than 1 - This denotes a volatility that is greater than the broad based index. Again, Beta greater than 100 - This is impossible as it essentially denotes a volatility that is 100 times greater than the market. If a stock had a beta of 100, it would be expected to go to 0 on any decline in the stock market. If you ever see a beta of over 100 on a research site it is usually the result of a statistical error, or the given stock has experienced large swings due to low liquidity, such as an over-the counter stock. For the most part, stocks of well-known companies rarely ever have a beta higher than 4.

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Advantages of Beta: 1) To followers of CAPM, beta is a useful measure. A stock's price variability is important to consider when assessing risk. Indeed, if you think about risk as the possibility of a stock losing its value, beta has appeal as a proxy for risk. 2) Intuitively, it makes plenty of sense. Think of an early-stage technology stock with a price that bounces up and down more than the market. It's hard not to think that stock will be riskier than, say, a safe-haven utility industry stock with a low beta. 3) Besides, beta offers a clear, quantifiable measure, which makes it easy to work with. Sure, there are variations on beta depending on things such as the market index used and the time period measured, but broadly speaking, the notion of beta is fairly straightforward to understand. It's a convenient measure that can be used to calculate the costs of equity used in a valuation method that discounts cash flows. Disadvantages of Beta: 1) For starters, beta doesn't incorporate new information. Consider the electrical utility company American Electric Power (AEP). Historically, AEP has been considered a defensive stock with a low beta. But when it entered the merchant energy business and assumed high debt levels, AEP's historic beta no longer captured the substantial risks the company took on. At the same time, many technology stocks, such as Google, are so new to the market they have insufficient price history to establish a reliable beta. 2) Another troubling factor is that past price movements are very poor predictors of the future. Betas are merely rear-view mirrors, reflecting very little of what lies ahead.

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3) Furthermore, the beta measure on a single stock tends to flip around over time, which makes it unreliable. Granted, for traders looking to buy and sell stocks within short time periods, beta is a fairly good risk metric. But for investors with long-term horizons, it's less useful. Formula for calculating Beta () = (cov (x y))/(var (x)) Where, X: Index Values Y: Stock Values 2. CAPITAL ASSEST PRICING MODEL (CAPM) The capital asset pricing model (CAPM) of William Sharpe (1964) and John Lintner (1965) marks the birth of asset pricing theory (resulting in a Nobel Prize for Sharpe in 1990). Four decades later, the CAPM is still widely used in applications, such as estimating the cost of capital for firms and evaluating the performance of managed portfolios. It is the centerpiece of MBA Investment courses. The Capital asset pricing model (CAPM) relates the risk-return trade-off of individual assets to market returns. The basic form of the CAPM is linear relationship between returns on the individual shares and the stock market returns over time. The capital asset pricing model is an attractive to the dividend valuation model and dividend growth model as a method as a model as a method of establishing the cost of equity. The uses of the capital asset pricing model (CAPM) include; trying to establish the correct equilibrium market price of companys shares, trying to establish the cost of a companys equity, taking account of the risk characteristics of a companys investments, both business and financial risk.

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CAPM theory includes the following propositions: 1. Investors in shares require a return in excess of the risk free rate, to compensate for the systematic risk. 2. Investor should not require a premium for unsystematic risk, because this can be diversified away by holding a wide portfolio of investments. 3. Because systematic risk varies between companies, investor will require a higher return from shares in those companies where the systematic risk is greater Systematic and Unsystematic Risk Systematic Risk is market risks that cannot be diversified away. Interest rates, recessions and wars are examples of systematic risks. Unsystematic Risk also known as "specific risk", this risk is specific to individual stocks and can be diversified away as the investor increases the number of stocks in his or her portfolio. In more technical terms, it represents the component of a stock's return that is not correlated with general market moves. Every investment portfolio has a risk element, which is the investor will always not be certain whether the investment will be able to generate income as per investors requirement. The degree of risk defers from industry to industry but also from company to company. It is not possible to eliminate the investment risk altogether but with careful diversification the risk might be minimized. Provided that the investor diversify their investments in a suitably wide portfolio, the investments which perform well and those which perform badly, should tend to cancel each other out, and much risk is diversified away. Risks that can be reduced through diversification are referred to as unsystematic risk as they are associated with a particular company or sector of the business. Remember investors are supposed to be compensated for any risk assumed, but with unsystematic risk the investor will not be have any extra risk premium as it can be eliminated through diversification. Some investments are by their nature

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more risky than others. These risks are called as systematic risk, which will always remain in an investment despite holding a well, diversified investment opportunities. If an investor would not take systematic risk, then should be prepared to settle for risk free return, which has a lower level of return. Where an investor assumes the systematic risk, and then should expect to earn a return, which is higher than a risk free rate of return. The amount of systematic risk in an investment varies between different types of investment. The Beta Factor and Risk Free Rate of Return A shares beta factor is the measures of measure of its volatility in terms of market risk. The beta factor of the market as a whole is 1.0. Market risk makes market returns volatile and the beta factor is simply a yardstick against which the risk of other investments can be measured. Risk or uncertainty describes a situation where there is not first one possible outcome but array of potential returns. Risk is measured as the beta factor or B. The market as a whole has B = 1 Risk free security has a B = 0 A security with a B < 1 is lesser risky than average Market A security with a B > 1 has risk above market Excess Return over Risk-free Return The CAPM also makes use of the principal that the returns on shares in the market as a whole are expected to be higher than the return of risk free investment as outlined above on Security market line. The difference between market returns and risk-free returns is called an excess return. For example, if the return on Malawis Treasury bill is 20% and market returns are 28%, the excess return on the market share as whole is 8%. The difference between the risk free return and the expected return on an individual security can be measured as the excess return for the market as a whole multiplied by the securitys beta factor. Summary of CAPM: CAPM is attractive:

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It is simple and sensible: * it is built on modern portfolio theory, * it Distinguishes systematic risk and non-systematic risk, * it provides a simple pricing model.

It is relatively easy to implement. It is difficult to test: * it difficult to identify the market portfolio, * it is difficult to estimate returns and betas. Empirical evidence is mixed.

CAPM is controversial:

EXPECTATION CALCULATOR CURRENT PRICE 207 BETA MARKET RETURNS RISK FREE RETURNS EXPECTED RETURNS EXPECTED PRICE AFTER 1 YR EXPECTED PRICE AFTER 3 MONTHS 3. VOLATILITY. Historical Volatility: Historical Volatility reflects the past price movements of the underlying asset, while implied volatility is a measure of market expectations regarding the asset's future Volatility. Historical volatility is also referred to as the asset's actual or realized volatility. There are different ways of measuring historical volatility. We use so-called closeto-close volatility. Historical close-to-close volatility (HV) is annualized standard 17 210.3861 220.5446 -0.0723 28 7.99 6.543277

deviation for close stock prices returns observed on a given time period N days. At present we calculate for all I Volatility stocks HV of terms: 10, 20, 30, and 60, 90, 120, 150, 180 days. Formulas:

Where: N Period of observation Pt Close price of t day t: From 1 to N+1

4. VALUE AT RISK (VAR). Value at risk (VAR) has been called the "new science of risk management", but you do not need to be a scientist to use VAR. we look at the idea behind VAR and the three basic methods of calculating it we apply these methods to calculating VAR for a single stock or investment. Methods of calculating VAR: 1. Historical Simulation 2. Model Building 3. Monte Carlo Simulation

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Historical Method The historical method simply re-organizes actual historical returns, putting them in order from worst to best. It then assumes that history will repeat itself, from a risk perspective. The QQQ started trading in Mar 1999, and if we calculate each daily return, we produce a rich data set of almost 1,400 points. Let's put them in a histogram that compares the frequency of return "buckets". For example, at the highest point of the histogram (the highest bar), there were more than 250 days when the daily return was between 0% and 1%. At the far right, you can barely see a tiny bar at 13%; it represents the one single day (in Jan 2000) within a period of five-plus years when the daily return for the QQQ was a stunning 12.4%!

Notice the red bars that compose the "left tail" of the histogram. These are the lowest 5% of daily returns (since the returns are ordered from left to right, the worst be always the "left tail"). The red bars run from daily losses of 4% to 8%. Because these are the worst 5% of all daily returns, we can say with 95% confidence that the worst daily loss will not exceed 4%. Put another way, we

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expect with 95% confidence that our gain will exceed - 4%. That is VAR in a nutshell. Let's re-phrase the statistic into both percentage and dollar terms: With 95% confidence, we expect that our worst daily loss will not exceed 4%. If we invest $100, we are 95% confident that our worst daily loss will not exceed $4 ($100 x -4%). You can see that VAR indeed allows for an outcome that is worse than a return of -4%. It does not express absolute certainty but instead makes a probabilistic estimate. If we want to increase our confidence, we need only to "move to the left" on the same histogram, to where the first two red bars, at -8% and -7% represent the worst 1% of daily returns: With 99% confidence, we expect that the worst daily loss will not exceed 7%. Or, if we invest $100, we are 99% confident that our worst daily loss will not exceed $7. The Variance-Covariance Method This method assumes that stock returns are normally distributed. In other words, it requires that we estimate only two factors standard deviation - which allows us to plot a normal distribution curve. Here we plot the normal curve against the same actual return data:

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The idea behind the variance method - we use the familiar curve instead of actual data. The advantage of the normal curve is that we automatically know where the worst 5% and 1% lie on the curve. They are a function of our desired confidence and the standard deviation (). CONFIDENCE 95% (HIGH) 99%( REALLY HIGH) # STANDARD DEVIATION () -1.65 * () -2.33*()

The blue curve above is based on the actual daily standard deviation of the QQQ, which is 2.64%. The average daily return happened to be fairly close to zero, so we will assume an average return of zero for illustrative purposes. Here are the results of plugging the actual standard deviation into the formulas above CONFIDENCE # OF 95% (HIGH) -1.65* 99% (REALLY -2.33* HIGH) CALCULATION -1.65*(2.65) -2.33*(2.33) EQUALS -4.36% -6.16%

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Monte Carlo Simulation The third method involves developing a model for future stock price returns and running multiple hypothetical trials through the model. A Monte Carlo simulation refers to any method that randomly generates trials, but by itself does not tell us anything about the underlying methodology. For most users, a Monte Carlo simulation amounts to a "black box" generator of random outcomes. Without going into further details, we ran a Monte Carlo simulation on the QQQ based on its historical trading pattern. In our simulation, 100 trials were conducted. If we ran it again, we would get a different result-although it is highly likely that the differences would be narrow. Here is the result arranged into a histogram (please note that while the previous graphs have shown daily returns, this graph displays monthly returns):

To summarize, we ran 100 hypothetical trials of monthly returns for the QQQ. Among them, two outcomes were between -15% and -20%; and three were between -20% and 25%. That means the worst five outcomes (that is, the worst 5%) were less than -15%. The Monte Carlo simulation therefore leads to the

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following VAR-type conclusion: with 95% confidence, we do not expect to lose more than 15% during any given month

5. RISK REWARD RATIO. A ratio used by many investors to compare the expected returns of an investment to the amount of risk undertaken to capture these returns. This ratio is calculated mathematically by dividing the amount of profit the trader expects to have made when the position is closed (i.e. the reward) by the amount he or she stands to lose if price moves in the unexpected direction (i.e. the risk). Let's say a trader purchases 100 shares of XYZ Company at $20 and places a stop-loss order at $15 to ensure that her losses will not exceed $500. Let's also assume that this trader believes that the price of XYZ will reach $30 in the next few months. In this case, the trader is willing to risk $5 per share to make an expected return of $10 per share after closing her position. Since the trader stands to make double the amount that she has risked, she would be said to have a 2:1 risk/reward ratio on that particular trade. The optimal risk/reward ratio differs widely among trading strategies. Some trial and error is usually required to determine which ratio is best for a given trading strategy. If there is a cornerstone to any trading philosophy, it starts at the risk to reward table. Although identifying good risk/reward trades does not guarantee success, not identifying good risk/reward trades almost always guarantees failure. Let's explore yet another important subject in the life of a trader and look at a trade setup we took late Friday in the context of this subject matter. Often, it's taken as simply the Return on our Portfolio, so we would say: (1) Risk/Reward = (Standard Deviation)/(Portfolio Return) Or, the Reward might be the Return on our Portfolio, over and above some riskfree rate, so we would say:

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(2) Risk/Reward = (Standard Deviation)/(Portfolio Return - Risk Free) The reciprocal of the Ratio in (2) is called the Sharpe Ratio. In Part I we saw that the Standard Deviation increases (sort of) as the square root of the time period. However, our Return, over longer and longer periods of time, increases more dramatically For example, suppose: Our annualized Portfolio Return was 8% so our Portfolio would grow according to (1.08) N, over N years, the annualized Standard Deviation (or Volatility) of our Portfolio was SD = 20% so this would grow as the years progressed as 0.2 SQRT (N) (according to that square-root-oftime stuff) The Ratio would be: SD / Return = 0.2 SQRT (N) / (1.08)^N

THE GARCH (1, 1) MODEL. GARCH (1, 1) is the simplest and most robust of the family of volatility models. However, the model can be extended and modified in many ways. I will briefly mention three modifications, although the number of volatility models that can be found in the literature is now quite extraordinary. The GARCH (1,1) model can be generalized to a GARCH (p, q) modelthat is, a model with additional lag terms. Such higher-order models are often useful when a long span of data is used, like several decades of daily data or a year of hourly data. With additional lags, such models allow both fast and slow decay of information. A particular specification of the GARCH (2,2) by Engle and Lee (1999), sometimes called the component model, is a useful starting point to this approach. ARCH/GARCH models thus far have ignored information on the direction of returns; only the magnitude matters. However, there is very convincing evidence that the direction does affect volatility. Particularly for broad-based equity indices and bond market indices, it appears that market declines forecast higher volatility than comparable market increases do. There is now a variety of asymmetric GARCH models, including the EGARCH

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model of Nelson (1991), the TARCH model threshold ARCH attributed to Rabemananjara and Zakoian (1993) and Glosten, Jag Nathan and Runkle (1993), and a collection and comparison by Engle and Ng (1993). The goal of volatility analysis must ultimately be to explain the causes of volatility. While time series structure is valuable for forecasting, it does not satisfy our need to explain volatility. The estimation strategy introduced for ARCH/GARCH models can be directly applied if there are predetermined or exogenous variables. Thus, we can think of the estimation problem for the variance just as we do for the mean. We can carry out specification searches and hypothesis tests to find the best formulation. Thus far, attempts to find the ultimate cause of volatility are not very satisfactory. Obviously, volatility is a response to news, which must be a surprise. However, the timing of the news may not be a surprise and gives rise to predictable components of volatility, such as economic announcements. It is also possible to see how the amplitude of news events is in uenced by other news events. For example, the amplitude of return movements on the United States stock market may respond to the volatility observed earlier in the day in Asian markets as well as to the volatility observed in the United States on the previous day. Engle, Ito and Lin (1990) call these heat wave and meteor shower effects. A similar issue arises when examine several assets in the same market. Does the volatility of one in uence the volatility of another? In particular, the volatility of an individual stock is clearly in uenced by the volatility of the market as a whole. This is a natural implication of the capital asset pricing model. It also appears that there is time variation in idiosyncratic volatility (for example, Engle, Ng and Rothschild, 1992). This discussion opens the door to multivariate modeling where not only the volatilities but also the correlations are to be investigated. There are now a large number of multivariate ARCH models to choose from. These turn out often to be difficult to estimate and to have large numbers of parameters. Research is continuing to examine new classes of multivariate models that are more convenient for fitting large covariance matrices. This is relevant for systems of

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equations such as vector auto regressions and for portfolio problems where possibly thousands of assets are to be analyzed.

GARCH (1,1) Sqrt

0.000746778 0.000841746 0.029012856 Final volatility=2.9%

0.000905058

0.000746778

6. MODERN PORTFOLIO THEORY Modern portfolio theory (MPT) proposes how rational investors will use diversification to optimize their portfolios, and how a risky asset should be priced. The basic concepts of the theory are Markowitz diversification, the efficient frontier, capital asset pricing model, the alpha and beta coefficients, the Capital Market Line and the Securities Market Line. MPT models an asset's return as a random variable, and models a portfolio as a weighted combination of assets; the return of a portfolio is thus the weighted combination of the assets' returns. Moreover, a portfolio's return is a random variable, and consequently has an expected value and a variance. Risk, in this model, is the standard deviation of the portfolio's return.

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Capital Market Line Risk and reward The model assumes that investors are risk averse. This means that given two assets that offer the same expected return, investors will prefer the less risky one. Thus, an investor will take on increased risk only if compensated by higher expected returns. Conversely, an investor who wants higher returns must accept more risk. The exact trade-off will differ by investor based on individual risk aversion characteristics. The implication is that a rational investor will not invest in a portfolio if a second portfolio exists with a more favorable risk-return profile - i.e. if for that level of risk an alternative portfolio exists which has better expected returns. Mean and variance It is further assumed that investor's risk / reward preference can be described via a quadratic utility function. The effect of this assumption is that only the expected return and the volatility (i.e. mean return and standard deviation) matter to the investor. The investor is indifferent to other characteristics of the distribution of returns, such as its skew. Note that the theory uses a historical parameter, volatility, as a proxy for risk, while return is an expectation on the future. 27

Recent innovations in portfolio theory, particularly under the rubric of PostModern Portfolio Theory (PMPT), have exposed many flaws in this total reliance on standard deviation as the investor's risk proxy. Under the model: 1. Portfolio return is the proportion-weighted combination of the constituent assets' returns. 2. Portfolio volatility is a function of the correlation of the component assets. The change in volatility is non-linear as the weighting of the component assets changes. Mathematically in general: Expected return:

(Where R is return)

Portfolio variance:

Portfolio volatility:

For a two asset portfolio: Portfolio return:

Portfolio variance:

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For a three-asset portfolio, the variance is:

As can be seen, as the number of assets (n) in the portfolio increases, the calculation becomes computationally intensive - the number of covariance terms = n (n-1) /2. For this reason, portfolio computations usually require specialized software. These values can also be modeled using matrices; for a manageable number of assets, these statistics can be calculated using a spreadsheet. Diversification An investor can reduce portfolio risk simply by holding instruments, which are not perfectly correlated. In other words, investors can reduce their exposure to individual asset risk by holding a diversified portfolio of assets. Diversification will allow for the same portfolio return with reduced risk. For diversification to work, the component assets must not be perfectly correlated, i.e. correlation coefficient not equal to 1. From the above formula we can derive that if all assets of a portfolio have a correlation of 0, the portfolio variance or volatility will be the weighted average of the individual instruments' volatility. If correlation is less than zero, that is, the assets are inversely correlated; the portfolio's volatility is less than the weighted average of the volatilities, and vice-versa. Capital allocation line The Capital Allocation Line (CAL) is the line of expected return plotted against risk (standard deviation) that connects all portfolios that can be formed using a risky asset and a risk less asset. It can be proven that it is a straight line and that it has the following equation.

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In this formula P is the risky portfolio, F is the riskless portfolio and C is a combination of portfolios P and F.

The efficient frontier

Efficient Frontier: Every possible asset combination can be plotted in risk-return space, and the collection of all such possible portfolios defines a region in this space. The line along the upper edge of this region is known as the efficient frontier (sometimes the Markowitz frontier). Combinations along this line represent portfolios for which there is lowest risk for a given level of return. Conversely, for a given amount of risk, the portfolio lying on the efficient frontier represents the combination offering the best possible return. Mathematically the Efficient Frontier is the intersection of the Set of Portfolios with Minimum Variance and the Set of Portfolios with Maximum Return. The efficient frontier is illustrated above, with return p on the y axis, and risk p on the x axis; an alternative illustration from the diagram in the CAPM article is at right.

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The efficient frontier will be convex this is because the risk-return characteristics of a portfolio change in a non-linear fashion as its component weightings are changed. (As described above, portfolio risk is a function of the correlation of the component assets, and thus changes in a non-linear fashion as the weighting of component assets changes.) The efficient frontier is a parabola (hyperbola) when expected return is plotted against variance (standard deviation). The region above the frontier is unachievable by holding risky assets alone. No portfolios can be constructed corresponding to the points in this region. Points below the frontier are suboptimal. A rational investor will hold a portfolio only on the frontier.

The risk-free asset The risk-free asset is the (hypothetical) asset which pays a risk-free rate - it is usually proxied by an investment in short-dated Government securities. The riskfree asset has zero variance in returns (hence is risk-free); it is also uncorrelated with any other asset (by definition: since its variance is zero). As a result, when it is combined with any other asset, or portfolio of assets, the change in return and also in risk is linear. Because both risk and return change linearly as the risk-free asset is introduced into a portfolio, this combination will plot a straight line in risk-return space. The line starts at 100% in cash and weight of the risky portfolio = 0 (i.e. intercepting the return axis at the risk-free rate) and goes through the portfolio in question where cash holding = 0 and portfolio weight = 1. Mathematically: Using the formulae for a two asset portfolio as above: 31

Return is the weighted average of the risk free asset, f, and the risky portfolio, p, and is therefore linear: Return =

Since the asset is risk free, portfolio standard deviation is simply a function of the weight of the risky portfolio in the position. This relationship is linear.

Standard deviation = = = = Portfolio leverage An investor can add leverage to the portfolio by borrowing the risk-free asset. The addition of the risk-free asset allows for a position in the region above the efficient frontier. Thus, by combining a risk-free asset with risky assets, it is possible to construct portfolios whose risk-return profiles are superior to those on the efficient frontier.

An investor holding a portfolio of risky assets, with a holding in cash, has a positive risk-free weighting (a de-leveraged portfolio). The return and standard deviation will be lower than the portfolio alone, but since the efficient frontier is convex, this combination will sit above the efficient frontier i.e. offering a higher return for the same risk as the point below it on the frontier.

The investor who borrows money to fund his/her purchase of the risky assets has a negative risk-free weighting -i.e a leveraged portfolio. Here the return is geared to the risky portfolio. This combination will again offer a return superior to those on the frontier. 32

The market portfolio The efficient frontier is a collection of portfolios, each one optimal for a given amount of risk. A quantity known as the Sharpe ratio represents a measure of the amount of additional return (above the risk-free rate) a portfolio provides compared to the risk it carries. The portfolio on the efficient frontier with the highest Sharpe Ratio is known as the market portfolio, or sometimes the superefficient portfolio; it is the tangency-portfolio in the above diagram. This portfolio has the property that any combination of it and the risk-free asset will produce a return that is above the efficient frontier - offering a larger return for a given amount of risk than a portfolio of risky assets on the frontier would.

Capital market line When the market portfolio is combined with the risk-free asset, the result is the Capital Market Line. All points along the CML have superior risk-return profiles to any portfolio on the efficient frontier. (The market portfolio with zero cash weighting is on the efficient frontier; additions of cash or leverage with the riskfree asset in combination with the market portfolio are on the Capital Market Line. All of these portfolio represent the highest Sharpe ratios possible.) The CML is illustrated above, with return p on the y axis, and risk p on the x axis. One can prove that the CML is the optimal CAL and that its equation is:

Asset pricing

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A rational investor would not invest in an asset which does not improve the riskreturn characteristics of his existing portfolio. Since a rational investor would hold the market portfolio, the asset in question will be added to the market portfolio. MPT derives the required return for a correctly priced asset in this context. Systematic risk and specific risk Specific risk is the risk associated with individual assets - within a portfolio these risks can be reduced through diversification (specific risks "cancel out"). Systematic risk, or market risk, refers to the risk common to all securities - except for selling short as noted below, systematic risk cannot be diversified away (within one market). Within the market portfolio, asset specific risk will be diversified away to the extent possible. Systematic risk is therefore equated with the risk (standard deviation) of the market portfolio. Since a security will be purchased only if it improves the risk / return characteristics of the market portfolio, the risk of a security will be the risk it adds to the market portfolio. In this context, the volatility of the asset, and its correlation with the market portfolio, is historically observed and is therefore a given (there are several approaches to asset pricing that attempt to price assets by modeling the stochastic properties of the moments of assets' returns - these are broadly referred to as conditional asset pricing models). The (maximum) price paid for any particular asset (and hence the return it will generate) should also be determined based on its relationship with the market portfolio. Systematic risks within one market can be managed through a strategy of using both long and short positions within one portfolio, creating a "market neutral" portfolio. Security characteristic line The Security Characteristic Line (SCL) represents the relationship between the market return (rM) and the return of a given asset i (ri) at a given time t. In

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general, it is reasonable to assume that the SCL is a straight line and can be illustrated as a statistical equation:

Where i is called the asset's alpha coefficient and i the asset's beta coefficient. Capital Asset Pricing Model The asset return depends on the amount for the asset today. The price paid must ensure that the market portfolio's risk / return characteristics improve when the asset is added to it. The CAPM is a model which derives the theoretical required return (i.e. discount rate) for an asset in a market, given the risk-free rate available to investors and the risk of the market as a whole. The CAPM is usually expressed:

, Beta, is the measure of asset sensitivity to a movement in the overall market; Beta is usually found via regression on historical data. Betas exceeding one signify more than average "riskiness"; betas below one indicate lower than average.

is the market premium, the historically observed excess return of the market over the risk-free rate.

Once the expected return, E(ri), is calculated using CAPM, the future cash flows of the asset can be discounted to their present value using this rate to establish the correct price for the asset. (Here again, the theory accepts in its assumptions that a parameter based on past data can be combined with a future expectation.)

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A more risky stock will have a higher beta and will be discounted at a higher rate; less sensitive stocks will have lower betas and be discounted at a lower rate. In theory, an asset is correctly priced when its observed price is the same as its value calculated using the CAPM derived discount rate. If the observed price is higher than the valuation, then the asset is overvalued; it is undervalued for a too low price. Mathematically: (1) The incremental impact on risk and return when an additional risky asset, a, is added to the market portfolio, m, follows from the formulae for a two asset portfolio. These results are used to derive the asset appropriate discount rate. Risk = Hence, risk added to portfolio = but since the weight of the asset will be relatively low, i.e. additional risk = Return = Hence additional return = (2) If an asset, a, is correctly priced, the improvement in risk to return achieved by adding it to the market portfolio, m, will at least match the gains of spending that money on an increased stake in the market portfolio. The assumption is that the investor will purchase the asset with funds borrowed at the risk-free rate, Rf; this is rational if Thus: .

i.e. : i.e. :

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is the beta, -- the covariance between the asset and the market compared to the variance of the market, i.e. the sensitivity of the asset price to movement in the market portfolio.

Securities market line The SML essentially graphs the results from the capital asset pricing model (CAPM) formula. The X-axis represents the risk (beta), and the Y-axis represents the expected return. The market risk premium is determined from the slope of the SML. The Security Market Line

The relationship between Beta & required return is plotted on the securities market line (SML) which shows expected return as a function of . The intercept is the risk-free rate available for the market, while the slope is .

The Securities market line can be regarded as representing a single-factor model of the asset price, where Beta is exposure to changes in value of the Market. The equation of the SML is thus:

It is a useful tool in determining if an asset being considered for a portfolio offers a reasonable expected return for risk. Individual securities are plotted on the SML graph. If the security's risk versus expected return is plotted above the SML, it is undervalued since the investor can expect a greater return for the inherent risk. And a security plotted below the SML is overvalued since the investor would be accepting less return for the amount of risk assumed. Comparison with arbitrage pricing theory

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The SML and CAPM are often contrasted with the Arbitrage pricing theory (APT), which holds that the expected return of a financial asset can be modeled as a linear function of various macro-economic factors, where sensitivity to changes in each factor is represented by a factor specific beta coefficient. The APT is less restrictive in its assumptions: it allows for an explanatory (as opposed to statistical) model of asset returns, and assumes that each investor will hold a unique portfolio with its own particular array of betas, as opposed to the identical "market portfolio". Unlike the CAPM, the APT, however, does not itself reveal the identity of its priced factors - the number and nature of these factors is likely to change over time and between economies. General forms of risk averse, risk neutral and risk loving preference functions are shown below:

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PORTFOLIO DESIGN / SELECTION Portfolios of assets can be compared on the basis of their risk and return characteristics. In this section we consider tools for analyzing portfolios. We need to know how to measure the risk and return characteristics of a given portfolio of securities. Two Asset Case The expected return of a two asset portfolio is simply a weighted average of the expected returns of each asset in the portfolio. 39

E[rp] = w1 E[r1] + (1-w1) E[r2]

(Eq 1)

where w1 and (1-w1) = w2 are the percentage of portfolio value invested in each asset. From basic statistics we also know that the variance of two random variables is a function of the variance of each variable and the covariance between the variables. This relationship directly applies in calculating the variance of a two asset portfolio as follows: (Eq 2) The N Asset Case For an N asset portfolio, the portfolio return is just the sum of the asset returns times the weights each of the assets has in the portfolio. In matrix notation, this is just the product: rp = w' r (Eq 3)

w is a vector containing the respective weights of the N assets. That is, if we have $1 million to invest and we place $100,000 in security i, then wi = 0.10. We define r as a vector containing the returns of the N assets. This product can be calculated in Excel using the sumproduct function. The weights must all sum to one. This means that all money must be allocated. The portfolio expected return is just the expected asset returns times the weights each of the assets has in the portfolio. The portfolio expected return is just the sum of the expected asset returns times the weights each of the assets has in the portfolio. If E is a vector containing the expected returns of the assets, then the portfolio's expected return can also be

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defined in terms of matrix multiplication. In Excel this operation can also be performed using the sum product function. Ep = w' E Note that the above formula expands to the formula above for the two asset case. E(rp) = w1 E(r1) + (1-w1) E(r2) The portfolio expected excess return is just the expected returns on the assets minus the risk free return (say a one month Treasury bill) times the weights each of the assets has in the portfolio. This value can also be expressed as a product of a (1 x N) matrix of weights with a (N x 1) matrix of excess returns (or in Excel using the sum product function). Xp = w'X Where X represents the expected excess returns on the various assets. The variance of the portfolio return is a little more complicated when there are more than two assets. It will still be a function of the weights, variances and covariances, but it is harder to express as a simple formula. It can be expressed, easily, as a product of matrices: (Eq 5) Where V is the variance-covariance matrix (variances along diagonal and covariances of the diagonal). The linear algebra is shown below for the two asset case.

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The matrix algebra for the N asset case can easily be implemented in Excel. The covariance of two portfolio returns, each denoted by their own set of weights, say wa, wb can also be found using matrix algebra. It is just: Cova,b = wa' V wb (Eq 6)

Where V is the variance-covariance matrix (variances along diagonal and covariances of the diagonal). Recall the formula for correlation. The correlation of portfolios with returns a and b is just the covariance divided by the product of the standard deviations. Distributional Assumptions Given an optimal choice for today's consumption, c0, the goal of a portfolio is to maximize the utility (expected) of future consumption provided by wealth at t = 1. This is a hard problem. Often we need to make a major assumption to simplify the problem. We will assume that asset returns are jointly normally distributed. The normal distribution has the property that the distribution can be completely described by two parameters: the mean and variance. The multivariate normal can be completely described by the means, variances and the covariances between the different assets. Note the variances and the covariances of the risk free asset are zero. A linear combination of normal random variables is normal. Therefore, wealth at t = 1 is normally distributed. The entire probability distribution of wealth is described by a portfolio's mean and variance. This all implies that a sufficient set of statistics to discriminate between portfolios is the mean and variance. This greatly simplifies the portfolio selection problem.

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Other Distributional Assumptions While most of finance is set in a mean-variance framework (which lends itself to using the normal distribution), there is some new work going on which tries to capture more general distributions. Harvey and Siddique (1995) have cast the portfolio selection in terms of mean-variance-skewness. This idea originates with important work in the 1970s. Harvey and Siddique make the means, variances and skewness dynamic processes which change with economic conditions. This paper is discussed in Global Tactical Asset Allocation. The Effect of Diversification Now let's consider the effect of diversification. We will examine a portfolio of two assets. From our formula for variance, we know:

Where

is the portfolio variance. For the two asset case:

Where

is the covariance between assets 1 and 2.

We could also write this in terms of correlation: (Eq 7) Where the sigma denotes the standard deviation of assets 1 and 2. For simplicity, assume in the following examples, that the variances of the two assets are equal, or = w2 = 0.50. and that the portfolio weights are identical, or w1

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Perfect Positive Correlation The first case of interest is that of perfect positive correlation. Using the formula:

This result demonstrates that the portfolio variance is the same as the variance for each asset. So diversification does not reduce the portfolio variance in this case. No Correlation The second case of interest is that of zero correlation. Again, plugging into the formula:

This result demonstrates that the portfolio variance is half of the variance of the individual assets. So combining stocks that have less than perfect positive correlation is a strategy that will reduce the variance of the returns on your portfolio. This is called diversification. Perfect Negative Correlation If two assets could be found which have perfect negative correlation, then we combine these assets to create a risk free portfolio:

These assets create a perfect hedge. This shows that diversification can be thought of as a partial hedge of risks.

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The following graphs tell the story. Suppose we randomly selected a stock and plotted its standard deviation. Now we randomly draw another stock and plot the standard deviation of the equally weighted portfolio. We continue the exercise. Just by randomly selecting stocks we can decrease portfolio variance. THE SHARPE MEASURE Consider investment in a riskless asset with a return of Rf and standard deviation of zero and a risky asset with mean return of Ee and standard deviation of . Let

the portfolio weight for the risky asset is w and the portfolio weight for the risk free asset must be 1-w. Now let's calculate the portfolio mean and standard deviation. We know the formulas for the portfolio mean and standard deviation for two assets: E [rp] = (1-w) Rf + w Ee

We can also write the expected returns equation as: E[rp] = Rf + w (Ee - Rf ) But we know from the standard deviation equation:

Substitute this formula for w into the expected returns equation.

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The term

is called the Sharpe Measure [Named after [William Sharpe] it

is used to evaluate investments. Below is a graph depicting the expected return-standard deviation space. The Sharpe measure is the slope of the line from Rf (rise is (E-Rf) over run which is STD). The intercept is the risk free rate, Rf.

The higher the Sharpe measure is the better the security looks. On the graph we could combine a strategy of borrowing and buying portfolio A to achieve the same expected return as portfolio B with a much smaller variance. Let's consider a specific example. Suppose:

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Just looking at portfolio A and B it is unclear which the best investment is. B has the higher return -- but it also has a higher variance. Let's first consider the Sharpe measures:

The measure suggests that portfolio B is dominated by a strategy of borrowing and holding portfolio A. Let's check this out by calculating the standard deviation of a levered portfolio of A that has exactly the same expected return as B: 0.25 = w (0.20) + (1-w) 0.08 Solving for weight w: W = 0.17/0.12 = 1.4167 This suggests that a strategy of investing 141.67% of your money in A and borrowing 41.67% at the rate of Rf = 8% will deliver a portfolio return of 25% which is exactly the portfolio return for B. Now lets check the standard deviation of this levered portfolio:

Note that the other terms in the portfolio variance drop out because the variance of the risk free asset is zero. We are left with a portfolio standard deviation of 28.33%, which is lower than the 30% for portfolio B. The levered portfolio that contains A has the same mean as B but a lower standard deviation. As a result, the levered portfolio with A is preferred to the investment in B. We can expand the analysis to include the all asset available in the market. We showed last time that only the positively sloped portion of the minimum variance

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frontier of risky assets satisfied our portfolio selection rules. Now let's introduce the risk free asset into the analysis. We can use the tools that we developed above the discriminate among the portfolios on the efficient frontier of risky assets. We will search for combination of the risk free asset and some risky portfolio that delivers the highest Sharpe measure. We know that the Sharpe measure is just the slope of the line that is drawn from the risk free rate on the expected return axis. The portfolio with the highest Sharpe measure is the tangency portfolio. So the best possible mean and standard deviation combinations are from the riskless and tangency portfolio. If 100% of your wealth is invested in the riskless asset, then your return is Rf and the standard deviation is zero. If 50% of your wealth is invested in the riskless asset and 50% of your wealth is in the tangency portfolio, then your portfolio lies in between Rf and M on the straight line. If 100% of your money is in the tangency portfolio, the expected return is the expected return on the tangency portfolio and your standard deviation is the standard deviation on the tangency portfolio. Finally, if you borrow money at the riskless rate and combine your borrowing with your initial wealth to buy the tangency portfolio, then your portfolio is to the right of M on the straight line. This straight line is called the Capital Market Line. Since total lending equals total borrowing in the economy, the tangency portfolio is the market portfolio. The market portfolio represents total invested wealth in risky assets. It is a portfolio with weights defined to be the total value of the asset divided by the total value of all risky assets. These weights are referred to as value weights.

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Suppose Assets 1 and 2 have expected returns and standard deviations as follows:

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Security Expected Return Standard Deviation 1 2 20% 10% 20% 16%

Furthermore, suppose that the returns of the two securities are perfectly negatively correlated with What is the expected return and standard deviation of a portfolio with equal weights in each security? Here we use equation 1 to compute the expected return of the portfolio: E[rp] = w1 E[r1]+(1-w1)E[r2] And since the weight of each asset is w1 = w2 = 0.5, we find that E[rp] = 0.5 (20%) + 0.5 (10%) = 15% We use equation 7 to compute the variance of the returns of the portfolio:

Plugging in the values for our 50/50 portfolio yields in which case the standard deviation of the returns of the portfolio is 0.02 = 2%. (0.52)(0.202) + (0.52)(0.162) + 2 (0.5)(0.5)(0.20)(0.16)(-1) = 0.0004 Recall that Asset 2 has an expected return of 10% and a standard deviation of 16%. Clearly this portfolio of equal weights in Asset 1 and Asset 2 is preferred to holding Asset 2 by itself since the portfolio has an expected return of 15% and a standard deviation of 2%.

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BIBLIOGRAPHY

Books: o NSEs Derivatives Core Module and Dealer module. o Understanding Futures and Options by John C. Hull. o Investments by William f. Sharpe. o Corporate finance by Prasanna Chandra. Websites: o www.reliancemoney.com o www.nseindia.com o www.bseindia.com o www.moneycontrol.com o www.indiabulls.com

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o www.investopedia.com NEWSPAPERS/ ARTICLES: o Economic Times o Times of India MAGAZINES: o Business world o Business Today

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