1
Capital Markets and Portfolio Analysis
2
Introduction Capital market theory springs from the
notion that:• People like return
• People do not like risk
• Dispersion around expected return is a reasonable measure of risk
3
Role of the Capital Markets Definition Economic function Continuous pricing function Fair price function
4
Definition Capital markets trade securities with lives
of more than one year
Examples of capital markets• New York Stock Exchange (NYSE)• American Stock Exchange (AMEX)• BSE• NSE
5
Economic Function The economic function of capital markets
facilitates the transfer of money from savers to borrowers• E.g., mortgages, Treasury bonds, corporate
stocks and bonds
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Continuous Pricing Function The continuous pricing function of capital
markets means prices are available moment by moment• Continuous prices are an advantage to investors
• Investors are less confident in their ability to get a quick quotation for securities that do not trade often
7
Fair Price Function The fair price function of capital markets
means that an investor can trust the financial system• The function removes the fear of buying or
selling at an unreasonable price
• The more participants and the more formal the marketplace, the greater the likelihood that the buyer is getting a fair price
8
The Life of every man is a diary in which he means to write one story, and writes
another; and his humblest hour is when he compares the volume as it is with what he
vowed to make it.
- J.M. Barrie
9
Investments Traditional investments covers:
• Security analysis– Involves estimating the merits of individual
investments
• Portfolio management– Deals with the construction and maintenance of a
collection of investments
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Security Analysis A three-step process
1) The analyst considers prospects for the economy, given the state of the business cycle
2) The analyst determines which industries are likely to fare well in the forecasted economic conditions
3) The analyst chooses particular companies within the favored industries
• EIC analysis
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The Portfolio Manager’s Job Begins with a statement of investment
policy, which outlines:• Return requirements
• Investor’s risk tolerance
• Constraints under which the portfolio must operate
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The Six Steps of Portfolio Management
1) Learn the basic principles of finance
2) Set portfolio objectives
3) Formulate an investment strategy
4) Have a game plan for portfolio revision
5) Evaluate performance
6) Protect the portfolio when appropriate
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Low Risk vs. High Risk Investments (cont’d)
1) Earns 10% per year for each of ten years (low risk)
• Terminal value is $25,937
2) Earns 9%, -11%, 10%, 8%, 12%, 46%, 8%, 20%, -12%, and 10% in the ten years, respectively (high risk)
• Terminal value is $23,642
The lower the dispersion of returns, the greater the terminal value of equal investments
14
Background, Basic Principles, and Investment Policy (cont’d)
There is a distinction between “good companies” and “good investments”• The stock of a well-managed company may be
too expensive• The stock of a poorly-run company can be a
great investment if it is cheap enough
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Background, Basic Principles, and Investment Policy (cont’d)
The two key concepts in finance are:1) A dollar today is worth more than a dollar
tomorrow
2) A safe dollar is worth more than a risky dollar
These two ideas form the basis for all aspects of financial management
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Background, Basic Principles, and Investment Policy (cont’d)
Setting objectives• It is difficult to accomplish your objectives
until you know what they are
• Terms like growth or income may mean different things to different people
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Portfolio Management Passive management has the following
characteristics:• Follow a predetermined investment strategy
that is invariant to market conditions or
• Do nothing
• Let the chips fall where they may
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PART THREEPortfolio Management
Active management:• Requires the periodic changing of the
portfolio components as the manager’s outlook for the market changes
8 - 19
Measuring ReturnsDollar Returns
Investors in market-traded securities (bonds or stock) receive investment returns in two different form:
– Income yield
– Capital gain (or loss) yield The investor will receive dollar returns, for example:
– $1.00 of dividends
– Share price rise of $2.00To be useful, dollar returns must be converted to percentage returns as a function of the original investment. (Because a $3.00 return on a $30 investment might be good, but a $3.00 return on a $300 investment would be unsatisfactory!)
8 - 20
Measuring ReturnsDollar Returns
Investors in market-traded securities (bonds or stock) receive investment returns in two different form:
– Income yield
– Capital gain (or loss) yield The investor will receive dollar returns, for example:
– $1.00 of dividends
– Share price rise of $2.00To be useful, dollar returns must be converted to percentage returns as a function of the original investment. (Because a $3.00 return on a $30 investment might be good, but a $3.00 return on a $300 investment would be unsatisfactory!)
8 - 21
Measuring ReturnsConverting Dollar Returns to Percentage Returns
An investor receives the following dollar returns a stock investment of $25:
– $1.00 of dividends
– Share price rise of $2.00
The capital gain (or loss) return component of total return is calculated: ending price – minus beginning price, divided by beginning price
%808.$25
$25-$27 return (loss)gain Capital
0
01
P
PP[8-2]
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Return on a Single Asset Total
return = Dividend + Capital gain
Year-to-Year Total Returns on HLL Share
149.70
70.54
16.52 22.71
49.52
92.33
36.13
52.64
7.29 12.95
0.00
20.00
40.00
60.00
80.00
100.00
120.00
140.00
160.00
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
Year
Tota
l R
etu
rn (%
)
1 1 01 011
0 0 0
Rate of return Dividend yield Capital gain yield
DIVDIV
P PP PR
P P P
23
Average Rate of Return The average rate of return is the sum of the
various one-period rates of return divided by the number of period.
Formula for the average rate of return is as follows:
1 2=1
1 1 = [ ]
n
n tt
R R R R Rn n
Measuring Average ReturnsGeometric Mean
Measures the average or compound growth rate over multiple periods.
11111(GM)Mean Geometric 1
321 -)]r)...(r)(r)(r [( nn[8-5]
CHAPTER 8 – Risk, Return and Portfolio Theory8 - 25
Estimating Expected Returns
The general formula
Where:ER = the expected return on an investment
Ri = the estimated return in scenario i
Probi = the probability of state i occurring
)Prob((ER)Return Expected 1
i
n
iir[8-6]
Estimating Expected Returns
Example:
This is type of forecast data that are required to make an ex ante estimate of expected return.
State of the EconomyProbability of Occurrence
Possible Returns on
Stock A in that State
Economic Expansion 25.0% 30%Normal Economy 50.0% 12%Recession 25.0% -25%
Estimating Expected Returns
Example Solution:
Sum the products of the probabilities and possible returns in each state of the economy.
(1) (2) (3) (4)=(2)×(1)
State of the EconomyProbability of Occurrence
Possible Returns on
Stock A in that State
Weighted Possible
Returns on the Stock
Economic Expansion 25.0% 30% 7.50%Normal Economy 50.0% 12% 6.00%Recession 25.0% -25% -6.25%
Expected Return on the Stock = 7.25%
Estimating Expected Returns
Example Solution:
Sum the products of the probabilities and possible returns in each state of the economy.
7.25%
)25.0(-25%0.5)(12% .25)0(30%
)Prob(r)Prob(r )Prob(r
)Prob((ER)Return Expected
332211
1i
n
iir
CHAPTER 8 – Risk, Return and Portfolio Theory8 - 29
Risk
Probability of incurring harm For investors, risk is the probability of earning
an inadequate return.• If investors require a 10% rate of return on a given
investment, then any return less than 10% is considered harmful.
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Risk of Rates of Return: Variance and Standard Deviation
Standard deviation = Variance
2
2
1
1
1
n
tt
R Rn
Measuring RiskExample Using the Ex post Standard Deviation
Problem
Estimate the standard deviation of the historical returns on investment A that were: 10%, 24%, -12%, 8% and 10%.
Step 1 – Calculate the Historical Average Return
Step 2 – Calculate the Standard Deviation
%88.121664
664
4
404002564
4
2020162
15
)814()88()812()824(8)-(10
1
)(post Ex
22222
222221
2_
n
rrn
ii
%0.85
40
5
10812-2410 (AM) Average Arithmetic 1
n
rn
ii
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Portfolio Return: Two-Asset Case The return of a portfolio is equal to the weighted
average of the returns of individual assets (or securities) in the portfolio with weights being equal to the proportion of investment value in each
asset. Expected return on portfolio weight of security × expected return on security
weight of security × expected return on security
X X
Y Y
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Portfolio Risk: Two-Asset Case The portfolio variance or standard deviation depends on
the co-movement of returns on two assets. Covariance of returns on two assets measures their co-movement.
The formula for calculating covariance of returns of the two securities X and Y is as follows:Covariance XY = Standard deviation X ´ Standard
deviation Y ´ Correlation XY The variance of two-security portfolio is given by the
following equation:
2 2 2 2 2
2 2 2 2
2 Co var
2 Cor
p x x y y x y xy
x x y y x y x y xy
w w w w
w w w w