4th Edition

CA Final
CMA Final
(New & Old Scheme)

Strategic Financial
Management (SFM)

Concept Summary

CA. Nagendra Sah

FCA, CFA L1, B. Sc. (H), Visiting faculty of ICAI, Stock
Market Expert, Highest Mark scorer in SFM, Best paper
award winner in Mathematics and Statistics in B. Sc.
Every effort has been made to avoid errors or omissions in this edition. In spite of this, error may creep in. Any mistake,
error or discrepancy noted may be brought to our notice which shall be taken care of in the next edition.

No part of this book may be reproduced or copied in any form or by any means without the written permission of the
publishers. Breach of this condition is liable for legal action.

© NS Learning Point (CA Nagendra Sah)

About Author
CA Nagendra Sah is a widely acclaimed Chartered Accountant in the field of Financial
Management, qualified Chartered Accountancy with highest Marks in Strategic Financial
Management (SFM). He teaches SFM to CA/CMA Final Students and Cost and Management
Account and FM & Eco for finance to CA-Inter Students. He has cleared all the levels of CA
examinations in first attempt. He completed 12th as well as Graduation in Science with
Statistics honours from the esteemed Tribhuvan University. He has been a University Topper
and awarded by University for securing highest marks in Statistics as well as Mathematics.
He is the premier author who wrote Strategic Financial Management (SFM) book for CA
Final, Cost and Management Accounting (CMA) and Financial Management & Economics for finance for CA
Intermediate.
His summary book is one of the most popular book among CA Students which is beneficial to revise whole syllabus
in less time with concept.
CA Nagendra Sah is a firm believer of conventional and customary practices being adopting in training and
coaching for over many years. He is a Chartered Accountant who took up teaching as profession, who believes in
a teaching methodology that relates to human brains.
His goal is not only to enable students to pass in CA Exam but also to provide tips and knowledge to earn money
from stock Market by trading in Equity, Bond, Derivative, Currency, commodity and unit of Mutual Fund. He is a
consistent profit maker in Stock market and he got winner’s certificate many times from reputed broker Zerodha.
His students get a practical linkage of concept with actual financial data of company and economy. They get
awareness of government policy, RBI policy, Fed policy, global market that affects Indian stock exchange.
CONTENTS
CHAPTER PAGES

1. Time Value of Money ………………….………………………………………………………………………….. 1.1 to 1.8

2. Foreign Exchange Exposure and Risk Management …………….…………………………………... 2.1 to 2.34

3. Mutual Fund ……..………………..………………………………………………………………………………….. 3.1 to 3.6

4. Derivative Analysis and Valuation.…………………………………………………………………………… 4.1 to 4.38

5. Portfolio Management …………..………………………………………………….…………………………….. 5.1 to 5.20

6. Security Valuation …….………….…………….…………………………………………….……………………. 6.1 to 6.32

7. Merger and acqusition …………………………………...………..…………………………………………..... 7.1 to 7.6

8. Interest Rate Risk Management ..……….……….…….…………..………………………………………….. 8.1 to 8.18

9. Corporate Valuation ………………..…………………………………………………………………………….. 9.1 to 9.4

10. International Financial Management ………………….…………………………………………………… 10.1 to 10.6

 






 




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Chapter - 5
PORTFOLIO MANAGEMENT
Contents
1. INTRODUCTION ....................................................................................................................................................................................................... 2
2. RETURN BASED ON CASH FLOWS .................................................................................................................................................................. 3
(A) RETURN OF A SECURITY ............................................................................................................................................................................. 3
(B) RETURN OF A PORTFOLIO .......................................................................................................................................................................... 4
3. RISK OF A SECURITY OR A STANDARD DEVIATION OF A SECURITY ............................................................................................. 4
4. CO-EFFECIENT OF VARIATION (CV) .............................................................................................................................................................. 4
5. DATA ANALYSIS FOR CORRELATION, SYSTEMATIC RISK AND UNSYSTEMATIC RISK .......................................................... 5
(A) POSITIVE CORRELATION ............................................................................................................................................................................ 5
(B) NEGATIVE CORRELATION .......................................................................................................................................................................... 5
(C) ZERO CORRELATION ..................................................................................................................................................................................... 6
6. CO-VARIANCE BETWEEN TWO SECURITIES ............................................................................................................................................. 6
7. CORRELATION COEFFICIENT BETWEEN TWO SECURITIES/MARKET......................................................................................... 6
8. STANDARD DEVIATION OF A PORTFOLIO .................................................................................................................................................. 6
9. BETA ............................................................................................................................................................................................................................. 7
(A) BETA OF A SECURITY .................................................................................................................................................................................... 7
(B) BETA OF A PORTFOLIO ................................................................................................................................................................................ 7
(C) BETA OF MARKET OR BETA OF NIFTY.................................................................................................................................................. 7
(D) BETA OF RISK FREE SECURITY ................................................................................................................................................................ 7
10. SYSTEMATIC RISK OF A SECURITY ................................................................................................................................................................. 8
11. UNSYSTEMATIC RISK OF A SECURITY .......................................................................................................................................................... 8
12. SYSTEMATIC RISK OF A PORTFOLIO ............................................................................................................................................................. 9
13. UNSYSTEMATIC RISK OF A PORTFOLIO ...................................................................................................................................................... 9
14. TOTAL RISK OF A PORTFOLIO .......................................................................................................................................................................... 9
15. RISK OF PORTFOLIO CONTAINING THREE SECURITIES [HARRY MARKOWITZ FORMULA] .............................................. 9
16. MEASURES FOR EVALUATING THE PERFORMANCE OF MUTUAL FUND ..................................................................................... 9
(A) SHARPE RATIO OR REWARD TO VARIABILITY ................................................................................................................................ 9
(B)TREYNOR RATIO OR REWARD TO VOLATILITY ................................................................................................................................ 9
(C) ALPHA OR JENSEN ALPHA .......................................................................................................................................................................... 9
17. FAIR EXPECTED RETURN OF A SECURITY OR RETURN BASED ON RISK FACTOR ............................................................... 10
(A) CAPM .................................................................................................................................................................................................................. 10
(B) APT OR APTM................................................................................................................................................................................................. 10
18. EXPECTED RETURN OF A PORTFOLIO....................................................................................................................................................... 11
(A) USING CAPM ................................................................................................................................................................................................... 11
 (B) USING APT ....................................................................................................................................................................................................... 11
19. SELECTION OF STOCK USING EXPECTED RETURN ............................................................................................................................. 11
20. LINEAR EQUATION OR STRAIGHT LINE ................................................................................................................................................... 11
21. DIFFERENT TYPES OF LINE FOR RISK & RETURN ANALYSIS......................................................................................................... 12
(A) SECURITY MARKET LINE (SML)............................................................................................................................................................ 12
(B) CAPITAL MARKET LINE(CML) ............................................................................................................................................................... 12
(C) CHARACTERISTICS LINE (CL) ............................................................................................................................................................... 12
22. APT EQUATION ..................................................................................................................................................................................................... 12
23. EFFICIENT PORTFOLIO ACCORDING TO HARRY MARKOWITZ ..................................................................................................... 13
24. PORTFOLIO REBALANCING ............................................................................................................................................................................ 13
(A) VARIABLE RATIO PLAN ............................................................................................................................................................................ 13
(B) CONSTANT RATIO PLAN ........................................................................................................................................................................... 13
(C) CONSTANT PROPORTION PORTFOLIO INSURANCE POLICY (CPPIP) ............................................................................... 13
25. MINIMUM RISK PORTFOLIO ........................................................................................................................................................................... 13
26. ASSETS BETA OR PROJECT BETA OR FIRM BETA................................................................................................................................. 14
27. PROXY BETA OR BETA OF NEW PROJECT ................................................................................................................................................ 14
28. REQUIRED RETURN OF A PROJECT ............................................................................................................................................................. 15
29. SHARPE OPTIMAL PORTFOLIO OR CUT-OFF POINT ........................................................................................................................... 15
30. CALCULATION OF CUT-OFF POINT ............................................................................................................................................................. 16
31. INVESTMENT STRATEGY ................................................................................................................................................................................. 16

INTRODUCTION
 Bundle of securities/ assets/ liabilities is known as portfolio.
 Under portfolio management, our objective is to maximize return and minimize risk.
 Portfolio management is also known as risk-return analysis.

S.N. Portfolio Amount

1 Share of MRF 3,00,000
Securities 2 Bond Of SBI 2,00,000
3 Units of Axis Mutual Fund 1,50,000
Liability 4 Borrowing (1,50,000)
Value of Portfolio 5,00,000

Value of Portfolio

Objective:
Maximize return & minimize
risk of this portfolio.
RETURN BASED ON CASH FLOWS
(A) RETURN OF A SECURITY
Return based on cash flow is calculated using following formula:
Inflow−outflow
Return = × 100
Outflow
Where, www.fmguru.org
Inflow of equity share = [Dividend + Price at End] CA Nagendra Sah
Outflow = Price at the beginning FCA, B. Sc. (H), CFAL1

OR
(D1+ P1 )− P0
Return = ×100
P0
Sometimes, we find data of more than one year/period. In this case, calculate average return for security
return.
SECURITY RETURN

USING PAST DATA USING FUTURE DATA WITH PROBABILITIES

Return of a security (R𝑠 ) =

𝑅1 + 𝑅2 + 𝑅3 +⋯ Expected return (R𝑠 )
𝑛
= (R1 × P1) + (R 2 × P2) + (R 3 × P3) +...of a security
Where,
Where,
R1 & R 2 & R 3 are different past returns.
R1 & R 2 & R 3 are different past returns.
n = Number of returns
P1 & P2 & P3 are probabilities of different
 This return is also termed as average return. returns
 This return is also termed as expected return.

Note:
In fact, above both returns are average return and hence word “average return” and “expected return” are
interchangeable.

Analysis:
For return normally we calculate compound return. However, period wise return misses when we calculate
compound return but we need period wise return to calculate volatility (i.e. risk of security). Hence, calculate
period wise return first and then average, if question requires to calculate both risk and return.

Explanation:
0Y 1Y 2Y 3Y

Price = 100 Price = 90 Price = 120 Price = 118

For above data, we can calculate both compounded return and simple return.

(a) Simple Return (b) Compounded Return

0Y 1Y 2Y 3Y
90−100
R1 = × 100 = -10%
100 Price = 100 Price = 118
120−90
R2 = × 100 = 33.33% 100 × (1+R) 3 = 118
90
118−120
R3 = × 100 = -1.66% www.fmguru.org 118 3
1
120
(1+R) = ( )
CA Nagendra Sah 100
−10+33.33−1.66 FCA, B. Sc. (H), CFAL1
R security = = 7.22% R = 0.0567 (i.e. 5.67%)
3

 If we have to calculate “only return” then calculate compounded return. However, if we have to calculate risk
and return both then go for simple return because we need more than one return to check volatility.
  In calculation of simple return, we can see volatility from -10% to 33.33% which is input data for
measurement of risk.
(B) RETURN OF A PORTFOLIO
Before calculating portfolio return, we must have to calculate security return using above concept.
R Portfolio = RA WA + R B WB + Rc Wc + …
Where,
A,B & C are different securities.
RA, RB & RC = Return of securities A, B & C respectively.
WA, WB & WC = Weight of Security A, B & C respectively.
Value of Security−A
WA = and so on.
Total Value of Portfolio
Note: If question is silent, assume equal investment.

RISK OF A SECURITY OR STANDARD DEVIATION OF A SECURITY

Standard deviation measures overall risk of a security. In fact, it is an average of Risk which depends upon data
fluctuation.
High fluctuation = High risk
Low fluctuation = Low risk
Zero fluctuation = Zero risk i.e. Risk free securities.
Measurement
www.fmguru.org
Average of deviation from mean is Standard Deviation (SD) CA Nagendra Sah
FCA, B. Sc. (H), CFAL1
Deviation = (X –X )
Where,
X = Mean of X (or average X)
X = Input data for which SD is to be calculated.
NOTE
Standard deviation measures the overall risk of a security. (Systematic risk as well as unsystematic risk)
For calculation of standard deviation, first calculate average of square of deviation after that do square root.
∑( x−x)2
Average of Square of Deviation [Variance] [𝜎 2 ] = OR ∑( x − x)2 × Probability
n

∑( x−x)2
SD (σ) = Square root of Variance = √ OR √∑( x − x)2 × Probability
n
Notes:
 Unit of Standard deviation is same as unit of input data.
 Standard deviation of same stock for different input may differ. Hence read question carefully to find input data.
(i.e. Price or return)
 If question is silent, we may use either price or return as input.
 If probability is given then calculate average (i.e. average of input data and average of square of deviation) using
probability.

CO-EFFECIENT OF VARIATION (CV)

Standard deviation per unit of mean of input data is known as coefficient of variation. It represents comparative
risk.
σ
CV =
x
CV is useful to decide risky stock when both risk and return moves in same direction.
DATA ANALYSIS FOR CORRELATION, SYSTEMATIC RISK AND UNSYSTEMATIC RISK
We can calculate systematic risk and unsystematic risk of a stock by correlating individual stock price/return change
with market (i.e. price/return change in NIFTY or SENSEX).

(A) POSITIVE CORRELATION

www.fmguru.org
(i) Perfect Market Condition NIFTY Point Stock-A Price CA Nagendra Sah
positive Bad 10700 500 FCA, B. Sc. (H), CFAL1
correction Good 11000 560
Normal 10850 530
• Here, behaviour of change in stock price and change in NIFTY is exactly same in same
direction.
• Correlation of this data must be “+1”
(i.e. 100% Positive Behaviour)
• 100% positive correlation indicates there is only systematic factor affect in change in
stock-A price. It means, total risk of stock-A is systematic risk.
(ii) Other than Market Condition NIFTY Point Stock-A Price
Perfect Bad 10700 500
Positive Good 11000 560
Correction Normal 10850 510

• Here, behaviour of movement on price of stock and NIFTY is in same direction but
movement is not exactly same.
• Correlation of above data must be lesser than “+1” (i.e. Fall between 0 to +1)
• It indicates, there is effect of Individual factor (i.e. unsystematic factor) also in movement
of stock-A price.

(B) NEGATIVE CORRELATION

(i) Perfect Market Condition NIFTY Point Stock-A Price
Negative Bad 10700 500
Correction Good 11000 440
Normal 10850 470
• Here, behavior of movement price of NIFTY and stock-A is exactly same in inverse
www.fmguru.org
direction.
CA Nagendra Sah
FCA, B. Sc. (H), CFAL1 • Correlation of this data must be “-1” (i.e. 100% negative correlation)
• It indicates there is effect of systematic factor in movement of price of stock -A.

Note: Practically, negative correlation between stock and market is not possible. In
short run, we may see negative correlation between IT Stock and NIFTY. Correlation
between $ and NIFTY remains negative in most of the time.
(ii) Other Perfect Market Condition NIFTY Point Stock-A Price
negative Bad 10700 500
correction Good 11000 440
Normal 10850 440
• Behaviour of movement in price of stock-A and NIFTY is not exactly same but in
inverse direction.
• Correlation of this data must fall between “-1 to 0”
• It indicates there is effect of unsystematic factor also.
 (C) ZERO CORRELATION
• Correlation of data must be Zero. It means there is no similarity in movement of price.
• It indicates there is no systematic factor effect on price movement of stock (i.e. Total
risk is unsystematic).
Examples - 1: Market Condition NIFTY Point Stock-A Price
Bad 10700 500 www.fmguru.org
Good 11850 560 CA Nagendra Sah
FCA, B. Sc. (H), CFAL1
Normal 11000 500
Examples - 2: Market Condition NIFTY Point Stock-A Price
Bad 10700 500
Good 11000 500
Normal 10850 500
Examples - 3: Market Condition NIFTY Point Stock-A Price
Bad 10700 500
Good 11000 500
Normal 10850 530

CO-VARIANCE BETWEEN TWO SECURITIES

Average of product of deviation of two securities/market is known as Co-variance.
We cannot interpret value of co variance because it represents square of data.
Co-variance of inverse relation securities must be negative.
Case Formula
I ∑(X − X ) ×(XB − XB )
Co-Variance between A & B = √ A A or√∑((XA − XA ) × (XB − XB ) ) × Probability
n
II Co-Variance between A & B = (σA × σ𝐁 ) × r (A,B) [Derived from formula of correlation]
III Covariance (A,B) = βA × βB × σ2m

CORRELATION COEFFICIENT BETWEEN TWO SECURITIES/MARKET

It indicates the similarity in movement of price/return of two stocks/market due to security.
Formula:
[𝐶𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 (𝐴,𝐵)]
Correlation coefficient between A & B (r A,B) = (𝜎𝐴 × 𝜎𝑩 )
Note:
(i) Value of ‘r’ must fall between -1 to + 1

STANDARD DEVIATION OF A PORTFOLIO

Portfolio risk can be calculated using following formula (2 securities portfolio):
σport = √(σA wA )2 + (σB wB )2 + 2 (σA wA ) (σB wB ) rAB
OR
= √(𝜎𝐴 𝑤𝐴 )2 + (𝜎𝐵 𝑤𝐵 )2 + 2 wA wB 𝐶𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒(𝐴, 𝐵)
 Above formula is derived from systematic risk and unsystematic risk of a portfolio [Derivation  Not required]
In few specific conditions, we can use following formulas which are derived from above formula (a):
(a) When r = +1 σport = (σA wA ) + (σB wB )
(b) When r = -1 σport = [(σA wA ) − (σB wB ) ] or [(σB wB ) − (σA wA ) ]
(c) When r = 0 σport = √(σA wA )2 + (σB wB )2
[But Both securities are risky]
(d) When r = 0 σport = (σA wA ) [When security B is risk free]
[But one security is risk free] σport = (σB wB ) [When security A is risk free]
When one security is risk free, rA,B = 0; σA = 0 (When A is risk free)
BETA
(A) BETA OF A SECURITY
Beta is a “sensitivity of systematic risk” of a stock in relation to market.
Formula:
r ×σ Covariance (A.M)
(i) βA = AM A OR
σ𝑀 σM × σM
Note:
(i) Security with beta higher than 1 is also known as aggressive stock.
(ii)Security with beta lower than 1 is also known as defensive stock.
(iii)Security with beta equal to 1 is also known as neutral stock.

Explanation:

rAM = 0.80
Stock-A Market
σ = 10% σ = 5% All systematic

Un Sys. Risk www.fmguru.org

Sys. Risk
CA Nagendra Sah
FCA, B. Sc. (H), CFAL1
= 10%×0.80 Balance But
= 8% not 2%

Sensitivity of systematic risk or proportion of systematic risk to

market risk (βA) = 8%/5% = 1.6 times

(B) BETA OF A PORTFOLIO

β Portfolio = β A×WA + βB×WB + ……
Where,
A&B are different stocks.
WA & WB are weight of investment in stock A & B respectively.
Value of A
WA = and so on.
Total Investment

(C) BETA OF MARKET OR BETA OF NIFTY

Market beta is “1”.
Verification:
Covariance(A,M)
βA = 2σm
Covariance(M,M) Variance Mkt. σ2
βM = = = m
=1
σ2
m σ2
m σ2
m

(D) BETA OF RISK FREE SECURITY

Beta of risk free stock = Zero
However, stock with zero beta may be risk free or may not be risk free.
Verification:
Correlation between A & Mkt. = 0
σA = 10% & σm = 5%
r ×σ 0 × 10
βA = AM A = =0
σM 5
Here, beta of stock is zero but stock is not risk free.
SYSTEMATIC RISK OF A SECURITY
Risk associated with market factor which affects entire stocks of market is known as systematic risk.
Some factors may be:
Government policy
GDP www.fmguru.org
CA Nagendra Sah
GNP FCA, B. Sc. (H), CFAL1
Inflation
Recession
Systematic risk can’t be mitigated through diversification. Hence, it is also known as non-diversifiable risk.

NS Opinion:
Systematic risk can also be mitigated through diversification if securities are negatively correlated (i.e. correlation
negative).

Formula:
(a) Systematic risk of a stock-A = σ𝐴2 × r𝐴,𝑚
2

OR
(b) Systematic risk of a stock-A = σ𝑚2 × B𝐴2

Note:
Normally, systematic & unsystematic risk are calculated in square term as Sharpe suggested formula is square term.
However, we can’t interpret value in square term. For interpretation, first do square root then interpret.

UNSYSTEMATIC RISK OF A SECURITY

 Risk associated with individual factor of a security which affects individual stock price/return is known as
unsystematic risk.
Some factors are
- Labour strike www.fmguru.org
CA Nagendra Sah
- Shortage of material FCA, B. Sc. (H), CFAL1
- Product quality
- Product price
- Bad management
 Unsystematic risk can be mitigated through portfolio diversification. Hence, it is also termed as diversifiable risk.
 Unsystematic risk can also be termed as:
(a) Unique risk
(b) Residual variance
(c) Random Error
(d) Diversifiable risk, etc.
 It is denoted by σ𝑒2 or σ∈2 or ∈ 2
Formula:
(a) σ𝑒(𝐴)
2
= σ𝐴2 − 𝑆𝑦𝑠𝑡𝑒𝑚𝑎𝑡𝑖𝑐 𝑟𝑖𝑠𝑘 𝑜𝑓 𝐴 (i.e. Total risk in square term – Systematic)
2
σ𝑒(𝐴) = σ𝐴2 − (σ𝐴2 × r𝑎,𝑚
2
)
= σ𝐴2 (1 − r𝑎,𝑚
2
)
In other way:
2
σ𝑒(𝐴) = 𝑆𝑦𝑠𝑡𝑒𝑚𝑎𝑡𝑖𝑐 𝑟𝑖𝑠𝑘 𝑜𝑓 𝐴 + 𝑈𝑛𝑠𝑦𝑠𝑡𝑒𝑚𝑎𝑡𝑖𝑐 𝑟𝑖𝑠𝑘 𝑜𝑓 𝐴
SYSTEMATIC RISK OF A PORTFOLIO
Systematic risk of a portfolio = σ𝑚2 × β𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
2

Caution:
Do not do weighted average of systematic risk for calculation of portfolio systematic risk. First calculate beta of portfolio
and then systematic risk of portfolio. [For Logic recall class discusstion]

UNSYSTEMATIC RISK OF A PORTFOLIO

σ2e(portfolio) = (𝜎𝑒(𝐴)
2 2
𝑤𝐴2 ) + (𝜎𝑒(𝐵) 2
𝑤𝐵2 ) + (𝜎𝑒(𝐶) 𝑤𝐶2 ) + ⋯

TOTAL RISK OF A PORTFOLIO

σ2(portfolio) = Systematic risk of portfolio + Unsystematic risk of portfolio
σ(portfolio) = √𝑆𝑦𝑠𝑡𝑒𝑚𝑎𝑡𝑖𝑐 𝑟𝑖𝑠𝑘 𝑜𝑓 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 + 𝑈𝑛𝑠𝑦𝑠𝑡𝑒𝑚𝑎𝑡𝑖𝑐 𝑟𝑖𝑠𝑘 𝑜𝑓 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜

Note:
 Above formula is also known as “Sharpe Index Model”.
 All concepts of systematic and systematic risk are given by “Sharpe”.
 Above formula of "σ(portfolio) ” is applicable for any number of securities in a portfolio.

RISK OF PORTFOLIO CONTAINING THREE SECURITIES [HARRY MARKOWITZ FORMULA]

(σA wA )2 + (σB wB )2 + (σC wC )2 (σA wA )2 + (σB wB )2 + (σC wC )2
+ 2 (σA wA ) (σB wB )rAB +2 wA wB Covariance(A, B)
σport =√ OR√
+ 2 (σB wB ) (σC wC )rBC + 2 wB wC Covariance(B, C)
+ 2 (σC wC ) (σA wA )rCA +2 wC wA Covariance(C, A)
Where,
Covariance(A, B) = σA σB rAB and so on.
Note:
Answers will remain same in both Sharpe Index Model & Harry Markowitz formula.

MEASURES FOR EVALUATING THE PERFORMANCE OF MUTUAL FUND

Following are some techniques to measure performance of mutual fund.
(A) SHARPE RATIO OR (B)Treynor Ratio or (C) ALPHA OR JENSEN ALPHA
REWARD TO Reward to Volatility www.fmguru.org
VARIABILITY CA Nagendra Sah
FCA, B. Sc. (H), CFAL1

Sharpe ratio of MF-A =

RA −RF Treynor ratio of MF-A = Excess return of a security/mutual fund over fair
σA RA −RF expected return (based on risk) is known as
Here, βA
Alpha.
R A = Return of MF-A (Cash Where,
flows-based return) βA = Beta of MF-A
Alpha (A) = R A − 𝐸𝑅𝐴
R F = Risk free return (R A − R F ) indicates
σA = Standard deviation of MF- reward Where,
A βA indicates volatility.
R A = Return of a security/mutual fund A (Based
(R A − R F ) indicates reward Hence, reward to
on cash flows)
σA indicates variability. R −R
volatility = A F 𝐸𝑅𝐴 = Expected return of A= 𝑅𝐹 + 𝛽𝐴 (RM - RF)
βA
Performance: Performance: Performance:
Higher Sharpe ratio = Better Higher Treynor ratio = +ve Alpha  Good performance
performance Better performance -ve Alpha  Bad performance
Zero  Required performance
FAIR EXPECTED RETURN OF A SECURITY OR RETURN BASED ON RISK FACTOR
 Fair expected return is calculated using risk factor.
High risk  High expected return/Required return
Low risk  Low expected return/Required return

 Following are two method to calculate return based on risk factor:

(A) CAPM (Capital Assets Pricing Model)
(B) APT (Arbitrage Pricing Theory)

(A) CAPM uses beta factor or sensitivity of systematic risk to calculate expected return.
CAPM As it uses single risk factor, it is also determined as single factor model to calculate
expected/required return.
Formula: www.fmguru.org
𝐸𝑅𝐴 = 𝑅𝐹 + 𝛽𝐴 (RM - RF) CA Nagendra Sah
FCA, B. Sc. (H), CFAL1
Where,
R F = Risk free return
βA = Sensitivity of systematic risk of stock-A
R M = Return of market
(R A − R F ) = Market risk premium
[Sometimes, it may be called risk premium]
Explanation:

Stock-A return β = 1.5 times NIFTY return

=? = 10%
Premium in stock
return for risk Premium in mkt.
= 1.5 times of 4% for risk = 4%
T-Bill = 6%
= 6%

It means return of stock-A must be = T-Bill return + Stock risk premium

= (6 + 6)% = 12%

Alternatively,
ER A = R F + βA (RM - RF) = 6% + 1.5(10-6) = 12%

(B)  APT uses both systematic risk factor and unsystematic risk factor in calculation of expected
APT return.
OR  As it uses more than one risk factor, it is also termed as “Multi factor model”
Formula:
APTM
𝐸𝑅𝐴 or 𝑅𝑅𝐴 = 𝑅𝐹 + 𝛽1 (RM1 - RF) + 𝛽2 (RM2 - RF) + 𝛽3 (RM3 - RF)
Where,
 1,2 & 3 indicates different factors like inflation, GDP, GNP, price of product, quality of
product, etc.
 𝛽1 , 𝛽2 , 𝛽3  Sensitivity of factor-1,2 & 3 respectively.
 (R 𝑀1 − R F ) = Market risk premium due to factor -1 and so on…

Second Formula:
ER A or RR A = λ0 + β1 λ1 + β2 λ2 + β3 λ3 +…
Where,
 λ0 = Risk free return
 𝛽1 , 𝛽2 , 𝛽3  Sensitivity of factor-1,2 & 3 respectively.
 λ1 , λ2 , λ3 = Change in market return due to factor 1,2 and 3 respectively.
EXPECTED RETURN OF A PORTFOLIO
(A) USING CAPM
(i) ER P or RR Portfolio = ER A WA + ER B WB + ER C WC + …
(ii) ER P or RR Portfolio = R F + βPort (R M − R F )
(B) USING APT
(i) ER P or RR Portfolio =ER A WA + ER B WB + ER C WC +…
(ii) ER P or RR Portfolio = R F + βF1 (port.) (R M1 - RF)
+ βF2 (port.) (RM2 - R F)
+ βF3 (port.)(RM3 - RF)

SELECTION OF STOCK USING EXPECTED RETURN

(a) ER is lesser than actual return based on cash flows
 Beneficial to buy (Alpha +ve)
 It indicates undervalue security.

(b) ER is greater than actual return based on cash flows

 Not beneficial to buy (Alpha –ve)
 It indicates over valued security.

LINEAR EQUATION OR STRAIGHT LINE

To form straight line, there must be two variables in an equation.
Standard format of straight line: y = mx + c
Where,
 y & x are two variables
 m & c are constant (i.e. any fixed number)
 m is slope of line
 c is intercept of line.

Example:
An equation of straight line:
y = 0.5x + 4
Here, slope of line is “0.5”. It means if x change by 1 then y change by 0.5 (i.e. if x change by 2 then y change by 1)
Intercept is 4. It means line starts from point 4 of y-axis (i.e. y is 4 when x is zero)
DIFFERENT TYPES OF LINE FOR RISK & RETURN ANALYSIS
Line

(A) SECURITY MARKET LINE (SML) (B) CAPITAL MARKET LINE(CML) (C) CHARACTERISTICS LINE (CL)

Relationship between expected Relationship between expected Relationship between Rs & mkt.
return & beta return & SD (𝜎) return
E.g.: ER = 0.5 𝜷 + 4 E.g.: ER = 0.5𝝈+ 4 E.g.: Rs = 0.5 𝑹𝑴 + 4

SML CML CL

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AR
ER

ER

CA Nagendra Sah
FCA, B. Sc. (H), CFAL1

Beta SD Rm

(A) Security Market Line (SML) (B) Capital Market Line (CML) (C) Characteristics Line (CL):

Graphical representation of It provides relationship between It provides relationship between

“CAPM” is also termed as SML. expected return and standard “actual return of a security” &
It provides relationship between deviation of a security. “market return”.
expected return and β.
Equation: Equation: Equation:
𝜎𝑠
𝐸𝑅𝐴 = 𝑅𝐹 + 𝛽 (RM - RF) 𝐸𝑅𝐴 = 𝑅𝐹 + (RM - RF) RS = Alpha + (𝛽 × RM)
𝜎𝑀
Where, RM − RF
 ER and 𝛽 are variables. = 𝑅𝐹 + 𝜎𝑠 ( ) Where,
𝜎𝑀
 (RM - RF) & R F are constant. Alpha = R S - (β × RM)
 Intercept of SML = R F Where,  RS = Return of a security based
 Slope of SML = (R M - RF)  ER & 𝜎𝑠 are variables. on cash flows
 It means we have to put value of  RF & (
RM − RF
) are constant.  RS & R M are variables.
“RF” and (R M - RF) in above 𝜎𝑀  Alpha and beta are constant (i.e.
equation to form SML.  Here, R F is intercept of line. put value of alpha & beta to
RM − RF
 Assume, R F = 4% & RM = 4.5% ( ) is slope of line. form CL equation)
𝜎𝑀
 Hence, intercept = 4% & slope = RM − RF  𝛽 is slope of line.
(4.5-4) = 0.5 ( ) is also termed as risk  Alpha is an intercept of line.
𝜎𝑀
 Hence, SML equation: return trade off Or Market Price  Alpha of CL is calculated using
ER = 0.5𝛽 +4 of Risk following formula.

APT EQUATION
It provides relationship between “expected return” and “beta of different factors”.
Equation:
As per APT,
𝐸𝑅𝐴 = 𝑅𝐹 + 𝛽1 (RM1 - RF)
+ 𝛽2 (RM2 - RF)
+ 𝛽3 (RM3 - RF)
Where,
 ER, 𝛽1 , 𝛽2 , 𝛽3 are variables.
𝑅𝐹 , (RM1 - RF), (RM2 - RF), (RM3 - RF) are constant.
EFFICIENT PORTFOLIO ACCORDING TO HARRY MARKOWITZ
According to Harry Markowitz, efficient portfolio is that portfolio which:
(a) Provides same return but undertakes less risk.
(b) Undertakes same risk but provides high return.
(c) Provides high return with high risk and low return with low risk.

PORTFOLIO REBALANCING
Maintaining proportion of equity investment (aggressive investment) and risk free bond investment (or conservative
investment) at equal time interval (i.e. each 15 days or each 1 month, etc.) or any fixed percentage change is known as
portfolio rebalancing.
 Objective of portfolio rebalancing is to maintain risk.
 There are different types of strategies.

RE-BALANCING STRATEGIES

(A) VARIABLE RATIO PLAN (B) CONSTANT RATIO PLAN (C) CONSTANT PROPORTION
PORTFOLIO INSURANCE
Maintain different ratio for Maintain same proportion POLICY (CPPIP)
different securities every time.
Say: 70:30, 60:40, etc. Normally, 50:50 See Below

(C) CONSTANT PROPORTION PORTFOLIO INSURANCE POLICY

In this strategy, equity investment value is calculated using following formula: www.fmguru.org
Equity Investment Value = (Total Portfolio Value – Floor Value) × m CA Nagendra Sah
FCA, B. Sc. (H), CFAL1
Risk free investment = (Total Portfolio Value – Equity Investment Value)
Where,
Floor value = Minimum value of portfolio in worst situation
M = Multiplier (It depends upon risk tolerance power.)

MINIMUM RISK PORTFOLIO

Two stocks portfolio risk can be minimised by maintaining following portion:

σB2 −Covariance(A,M)
(a) WA =
σB2 +σA2 −2 Covariance (A,B)
(b) WB = (1- WA)

(Above formula is derived from “σ𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 ” formula using concept of minimization (mathematic concept).

FORMULA FOR SPECIFIC CONDITION:

(a) When If r = -1, risk can be minimized to zero. In this case, we can use above formula also [i.e. formula (i)
r = -1 & (ii)] but following formula saves time.
σ
WA = B
σB +σA
(b) When In this case also, risk can be minimized to zero by maintaining –ve weight of one security (i.e.
r = +1 Borrowing or short sell)
σ
WA = B
σB −σA
ASSETS BETA OR PROJECT BETA OR FIRM BETA
In this concept, we are going to study relationship between “Assets beta” and “equity beta”.
B/S OF A COMPANY
Particulars Amount Particulars Amount
𝛽𝐸 Equity XXX Project A XXX 𝛽𝐴

𝛽𝐷 Debt XXX Project B XXX 𝛽𝐵

TOTAL XXX TOTAL XXX

Average beta of equity & debt is βAssets = βA WA + βB WB

equal to beta of Assets.
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E D(1 − T) CA Nagendra Sah
βAssets = βE × + βD × FCA, B. Sc. (H), CFAL1
E + D(1 − T) E + D(1 − T)

Note:
To incorporate tax saving, we used D × (1 − T) in calculation of weight. Here, T = Tax Rate
Unless otherwise stated, Assume 𝛽𝐷 = 𝑍𝑒𝑟𝑜
Analysis:
 When there is debt:𝛽𝐸 > 𝛽𝐴𝑠𝑠𝑒𝑡𝑠
 When there is no debt: 𝛽𝐸 = 𝛽𝐴𝑠𝑠𝑒𝑡𝑠
 If increase debt proportion: 𝛽𝐸 increase.
 𝛽𝐸 depends upon 𝛽𝐴𝑠𝑠𝑒𝑡𝑠 and capital mix.
 𝛽𝐴𝑠𝑠𝑒𝑡𝑠 depends upon performance of business.

PROXY BETA OR BETA OF NEW PROJECT

 Beta of new product is forecasted using beta of similar risk/similar business company and it is known as proxy
beta.
 Always use beta assets of proxy entity to calculate beta of new project.

B/S OF ABC Ltd.

Particulars Amount Particulars Amount
Project A (Existing pharma) XXX
Project B (IT New) XXX 𝛽 =?
TOTAL XXX TOTAL XXX

Few companies beta of same industry

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Infosys TCS Wipro CA Nagendra Sah
βAssets = 2 βAssets = 2.5 βAssets = 1.8 FCA, B. Sc. (H), CFAL1
2 + 2.5 + 1.80
βIT Industry =
3
= 2.10

If question is silent, assume

βIT (ABC) = 2.10 (i. e. βIT Industry )
Note:
Sometimes question provides information of individual risk factor of industry and ABC ltd. In this situation, adjust proxy
beta to calculate desired beta.
REQUIRED RETURN OF A PROJECT
Required return of a project can be calculated using “Assets side risk” or Liability side risk”.

B/S OF A COMPANY
Particulars Amount Particulars Amount
𝛽𝐸 Equity XXX Project A XXX 𝛽𝐴

𝛽𝐷 Debt XXX
TOTAL XXX TOTAL XXX

Average beta of equity & debt is RR of project-A = 𝑅𝐹 + 𝛽𝑃𝑟𝑜𝑗𝑒𝑐𝑡−𝐴 (RM - RF)

equal to beta of Assets.
RR of project-A = WACC
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WACC = KE WE + KD WD CA Nagendra Sah
FCA, B. Sc. (H), CFAL1
Where,
KE = R F + βE (RM - RF)
KD= Post tax cost of debt.
Note:
(a) If “RF = KD” and “Tax = NIL” then RR calculated using both methods remain same.
(b) If “RF ≠ KD” and “Tax ≠ NIL” then answers will differ. In this case, prefer WACC.

SHARPE OPTIMAL PORTFOLIO AND CUT-OFF POINT

It is a complete theory of selection of best stock in portfolio and calculation of proportion of investment in that
selected stock.
Constitution of Portfolio:
(a) Calculate excess return to beta (ERB) for each stock.
𝑅𝑆 −𝛽𝐹
ERB =
𝛽𝑆
Where,
𝑅𝑆 = Return of security (Cash flow based); 𝑅𝐹 = Risk free return; 𝛽𝑆 = Beta of security
Note: In fact, it is same ratio as provided by Treynor.

(b) Calculate cut-off point

Cut off point is a minimum value of ERB which is to be selected in optimal portfolio.
For calculation of cut-off point, refer next concept.

(c) Selection of stocks

Select all stocks whose ERB is higher than cut off point.

(d) Calculate proportion of investment in selected stocks

Calculate Z value using following formula for each selected stocks.
BS
ZS = (ERBS – Cut-off point) × 2
σ𝑒(𝑠)

Here, S = Security (Selected Security in portfolio)

Proportion of investment  Z1 :Z2 :Z3
[Assumed selected securities are 1,2&3). It means:
𝑧1 𝑧2 𝑧3
W1: W2: W3:
𝑧1 +𝑧2 +𝑧3 𝑧1 +𝑧2 +𝑧3 𝑧1 +𝑧2 +𝑧3
CALCULATION OF CUT-OFF POINT
Remember cut-off point calculation formula in the following sequence (i.e. stepwise)
Steps Particulars
I Arrange securities in descending order of ERB (Excess Return to Beta)
II Calculate: (R S − βF ) × β for each stock in above order.
III Calculate
(RS −βF )× β
for each stock.
σ2
Є

IV Calculate cumulative value of point (III) for each stock in above order.
V Calculate
𝛽2
for each stock in above order.
𝜎Є2

VI Calculate cumulative value of point (V) for each stock in above order.
VII Calculate: (Ci Value) =
𝛔𝟐
𝐌 × 𝐩𝐨𝐢𝐧𝐭 (IV) 𝐯𝐚𝐥𝐮𝐞
for each stock in above order
𝟏 +(𝛔𝟐
𝐌 × 𝐩𝐨𝐢𝐧𝐭 (VI)𝐯𝐚𝐥𝐮𝐞)

VIII Highest value of Ci is cut off point.

INVESTMENT STRATEGY
S.N. SITUATION ACTION
1 If actual return (Based on cash flow) is
higher than fair return (Based on risk factor)  Buy security because it is undervalued.
In this case, Alpha is Positive
2 If actual return is lesser than fair return  Sell security because it is overvalued.
In this case, Alpha is Negative
3 If actual return is equal to fair return  Hold security as it is fairly priced.
In this case, Alpha is Zero

FORMULA SUMMARY
 1. PORTFOLIO MANAGEMENT

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RETURN CA Nagendra Sah RISK
FCA, B. Sc. (H), CFAL1

Actual Return (Cash Flows Based) Required Return (Risk Based) Overall Risk (σ or 𝛔𝟐 )
Std. Dev.(σ) measures overall risk. However, calculate variance (σ2) as
Inflow−Outflow CAPM APTM overall risk for segregation in systematic risk and unsystematic risk.
Return = × 100
Outflow [For calculation of Standard deviation see next page]
[Capital Assets Pricing [Arbitrage Pricing Theory
𝐃𝟏 + 𝐏𝟏 −𝐩𝟎 Variance of a security/Port (𝝈𝟐 )
= Model] OR Model] OR
𝐏𝟎
Single Factor Model [Multi Factor Model]
Sys risk of a security Un-Sys risk of a sec A [𝛔𝟐𝐞(𝐀) ]
Return of a Security ER of a Security ER of a Security
2 = σ2A - Sys Risk of A
Case-I: Expected Return of A Expected Return (ER) = (σ2A × rs,m ) OR (σ2M × β2A )
Future Data with Probability ER A = R F + βA (RM - RF) = R F + βF1 (R M1 − R F ) Where, Or
2 2
Expected Return of Security A + βF2 (R M2 − R F ) rs,m = Coefficient of determination = σ2A × (1- rs,m )
= (R1 × P1 ) + (R2 × P2 ) + (R3 × Where, + βF3 (R M3 − R F ) + …
R F = Risk Free Return Sys risk of a Portfolio Un-Sys risk of a Port [𝛔𝟐𝐞(𝐏𝐨𝐫𝐭) ]
P3 ) + …
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βA = Beta of Security A OR
CA Nagendra Sah = σ2M × β2Port = (σ2e(A) wA2 ) + (σ2e(B) wB2 ) +
FCA, B. Sc. (H), CFAL1 [Sensitivity of ER = λ0 + βF1 λ1 + βF2 λ2 +…
Case-2:
Systematic Risk in
βPort = βA WA + βB WB + βC WC (σ2e(C) wC2 ) + ⋯ …
Past data without Probability
relation to Market] Where,
Average Return of security A
RM = Market Return λ0 = Risk Free return This risk can’t be mitigated This risk can be mitigated
R1 + R2 + R3 +⋯
= RM - RF = Market Premium λ1 = Change in market return through portfolio diversification. through portfolio diversification.
n due to factor -1 It is also known as diversifiable
It is also known as Non-
Diversifiable risk or Market risk risk or unique risk or Residual
Return of a Portfolio ER of a Portfolio ER of a Portfolio or variance explained by Market variance or random error or
ER Port ER Port Index. variance not explained by Market
Rport = R A WA + R B WB + R C WC + …. Index.
= ER A WA + ER B WB + ER C WC =ER A WA + ER B WB + ER C WC
OR OR We can also say: 𝜎𝐴2 = Sys Risk of A + UnSys risk of A
Where,
ER P = R F + βPort (RM − RF ) ER P = RF + βF1 (port.) (RM1 - RF) [It is also known as Sharpe Index Model]
R A , R B & R C = Return on security A, + βF2 (port.) (RM2 - RF)
B &C Comparison between β and Systematic risk
Where, + βF3 (port.)(RM3 - RF) Suppose, EBT is 1.5 times of EAT, and EAT is 12% then EBT is
WA , WB & WC = Weight of Where,
investments in A, B & ER A , ER B & ER C = Expected = (1.5 X 12%) = 18%.
return of A, B and C using ER A , ER B & ER C = Expected
C respectively return of A, B and C using Here we can say, EBT is 18% and sensitivity of EBT is 1.5 times.
CAPM
APTM In same way we can interpret β as sensitivity of systematic risk
while systematic risk is in square of % term.
 2. STANDARD DEVIATION (𝝈)
It measures overall risk of a security. In fact, it is an “average of deviation from mean” Calculated from square of data. For SD, first calculate variance which is “average of square
of deviation” and then do square root.

Of a security Of a portfolio

Case-1: For Two Securities For Three Securities

Future data with probability
SD (σSec ) = √∑(X − 𝑥)2 × Prob. Case-I (Normal) Harry Markowitz Formula
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CA Nagendra Sah
σport =
(σA wA )2 + (σB wB )2
FCA, B. Sc. (H), CFAL1 σport = √
Where, +2 (σA wA ) (σB wB ) rAB (σA wA )2 + (σB wB )2 + (σC wC )2
X = Return or Price +2 (σA wA ) (σB wB )rAB
OR √
𝑥 = Mean Return or Price + 2 (σB wB ) (σC wC )rBC
(𝜎𝐴 𝑤𝐴 )2 + (𝜎𝐵 𝑤𝐵 )2 + 2 (σC wC ) (σA wA )rCA
(X − 𝑥) = Deviation of return or price =√
+ 2 wA wB 𝐶𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒(𝐴, 𝐵)

Case-2: Case-II (r = +1) OR

Past data without probability σport = (σA wA ) + (σB wB )
∑(X − 𝑥)2 Case-III (r = -1) (σA wA )2 + (σB wB )2 + (σC wC )2
SD (σSec ) = √
𝑛 σport = (σA wA ) − (σB wB ) +2 wA wB Covariance(A, B)
√
+ 2 wB wC Covariance(B, C)
= (σB wB ) − (σA wA )
 Unit of Standard deviation is same as unit of input data. +2 wC wA Covariance(C, A)
Case-IV (r = 0 but both are risky)
For Example
SD of price = xxx σport = √(σA wA )𝟐 + (σB wB )𝟐 Where,
SD of return = (xx) % Case-V (r = 0 but one is risk free) Covariance(A, B) = σA σB rAB
 Standard deviation of same stock for different input may differ, σport = σA wA [When B is Risk Free] And so on…..
hence read question carefully to find input data (i.e. Price or www.fmguru.org
σport = σB wB [When A is Risk Free] CA Nagendra Sah
return) FCA, B. Sc. (H), CFAL1
 If question is silent, we may use either price or return as input.
 If probability is given then calculate average (i.e. average of
input data and average of square of deviation) using In all cases Answer will be same.
probability. For any number of securities (Sharpe index model)

σport = √Portfolio Systematic risk + Portfolio Unsystematic Risk

3. CV, CO-VARIANCE AND CORRELATION COEFFICIENT
𝛔
CO- EFFICIENT OF VARIANCE CV =
𝐱

∑(𝐗 𝐀 − 𝐗 𝐀 ) ×(𝐗 𝐁 − 𝐗 𝐁 )
=√ or√∑((𝐗 𝐀 − 𝐗 𝐀 ) × (𝐗 𝐁 − 𝐗 𝐁 ) ) × 𝐏𝐫𝐨𝐛𝐚𝐛𝐢𝐥𝐢𝐭𝐲
𝐧
CO-VARIANCE (A, B)
= 𝝈𝑨 × 𝝈𝑩 × 𝒓𝐀,𝐁
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= 𝛃𝑨 × 𝛃𝑩 × 𝝈𝟐𝒎 CA Nagendra Sah
FCA, B. Sc. (H), CFAL1
CORRELATION COEFFICIENT =
[𝑪𝒐𝒗𝒂𝒓𝒊𝒂𝒏𝒄𝒆 (𝑨,𝑩)]

BETWEEN A & B (𝒓𝐀,𝐁 ) (𝝈𝑨 × 𝝈𝑩 )

4. BETA
BETA OF A SECURITY βA =
𝐫𝐀𝐁 ×𝛔𝐀
OR
𝐂𝐨𝐯𝐚𝐫𝐢𝐚𝐧𝐜𝐞 (𝐀.𝐌)
𝛔𝑴 𝝈𝟐
𝒎
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BETA OF A PORTFOLIO βPortfolio = βA×WA + βB×WB + …… CA Nagendra Sah
FCA, B. Sc. (H), CFAL1
MARKET OR NIFTY BETA 1
RISK-FREE SECURITY BETA Zero

5. MEASURES FOR EVALUATING THE PERFORMANCE OF MUTUAL FUND

SHARPE RATIO OF MF-A =
𝐑𝐀 −𝐑𝐅
𝛔𝐀
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TREYNOR RATIO OF MF-A =
𝐑𝐀 −𝐑𝐅
𝛃𝐀 CA Nagendra Sah
FCA, B. Sc. (H), CFAL1
ALPHA (A) = 𝐑 𝐀 − 𝑬𝑹𝑨

6. MINIMUM RISK PORTFOLIO

𝛔𝑩𝟐 −𝑪𝒐𝒗𝒂𝒓𝒊𝒂𝒏𝒄𝒆(𝑨,𝑴)
WA = www.fmguru.org
MINIMUM RISK PORTFOLIO 𝛔𝑩𝟐 +𝛔𝑨𝟐 −𝟐 𝑪𝒐𝒗𝒂𝒓𝒊𝒂𝒏𝒄𝒆 (𝑨,𝑩)
CA Nagendra Sah
WB = (1- WA) FCA, B. Sc. (H), CFAL1

7. PORTFOLIO REBALANCING
VARIABLE RATIO PLAN Maintain different ratio for different securities
CONSTANT RATIO PLAN Maintain same proportion every time.
CONSTANT PROPORTION Equity Investment Value = (Total Portfolio Value – Floor Value) × m
PORTFOLIO INSURANCE POLICY
(CPPIP) Risk free Bond invest. = (Total Port. Value – Equity Invest. Value)

8. ASSETS BETA OR PROJECT BETA OR FIRM BETA

βAssets = (βProject A × WProject A ) + (βProject B × WProject B )
ASSET BETA E D(1−T)
βAssets = βE × E+D(1−T) + βD × E+D(1−T)

9. REQUIRED RETURN OF A PROJECT

REQUIRED RETURN R F + βASSETS (RM - RF)
(USING ASSET SIDE RISK) www.fmguru.org
WACC = 𝐊E WE + 𝐊D WD CA Nagendra Sah
REQUIRED RETURN FCA, B. Sc. (H), CFAL1
Where, KE = R F + βE (RM - RF)
(USING LIBILITY SIDE RISK)
KD = Post tax cost of debt.
10. DIFFERENT TYPES OF LINE FOR RISK & RETURN ANALYSIS
ER A = R F + β (RM - RF)
SECURITY MARKET LINE (SML)
ER and β are variables. (RM - RF) & RF are constant.
𝛔𝐬 𝐑𝐌 − 𝐑𝐅
𝐄𝐑 𝐀 = 𝐑 𝐅 + (RM - RF) OR 𝐄𝐑 𝐀 = 𝐑 𝐅 + 𝛔𝐬 ( ) www.fmguru.org
𝛔𝐌 𝛔𝐌
CAPITAL MARKET LINE (CML) RM − RF
CA Nagendra Sah
ER & σs are variables. RF & ( ) are constant. FCA, B. Sc. (H), CFAL1
σM
RS = Alpha + (𝛃 × RM) Where, Alpha = RS - (β × RM)
CHARACTERISTIC LINE (CL)
RS & RM are variables. Alpha and beta are constant

11. SHARPE OPTIMAL PORTFOLIO

CALCULATE EXCESS RETURN TO 𝐑𝐒 −𝛃𝐅
ERB =
BETA (ERB) FOR EACH STOCK. 𝛃𝐒

Cut off point is a minimum value of ERB which is to be selected in optimal

portfolio.
Steps Particulars
I Arrange securities in descending order of ERB (Excess Return
to Beta)
II Calculate: (R S − βF ) × β for each stock in above order.
III (R −β )× β
Calculate S F for each stock.
CALCULATE CUT-OFF POINT σ2
Є

IV Calculate cumulative value of point (III) for each stock in above

www.fmguru.org order.
CA Nagendra Sah V 𝛽2
FCA, B. Sc. (H), CFAL1 Calculate for each stock in above order.
𝜎Є2

VI Calculate cumulative value of point (V) for each stock in above

order.
VII Calculate: (Ci Value) =
𝛔𝟐
𝐌 × 𝐩𝐨𝐢𝐧𝐭 (IV) 𝐯𝐚𝐥𝐮𝐞
for each stock in
𝟏 +(𝛔𝟐
𝐌 × 𝐩𝐨𝐢𝐧𝐭 (VI)𝐯𝐚𝐥𝐮𝐞)
above order
VIII Highest value of Ci is cut off point.
SELECTION OF STOCKS Select all stocks whose ERB is higher than cut off point.
CALCULATE PROPORTION OF Z = (ERB – Cut-off point) ×
BS
2
INVESTMENT IN SELECTED σe(s)

STOCKS Proportion of Invest.: Z1: Z2: Z3 (Assuming Selected Security are 1,2 & 3)
 






 




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