I" I

I
I

*' ~-
I \ \II\ i,..
7 :. \ \\I•I II i
') ~ ~ -' ,:_ __:,}* 4
(
\ dl ~y( i: ~
,,, \ (1\\,1 \
i< ,;, l I
, S'~d ; \iJ' ~ -
@. '1 (r' . ,,,
\ iI
' ,J b- ,- I ~ ..
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169 /) 15 I.

\ I ' \

·,. , '1
ASSET PRICINSt·/MO DE L (CAPM) i;1 I
:--- . ,,.tf':-•F - - -- - · - -
~L 'yf'
\l

~ 1

1,\
I\ .
ricing model was devel oped in mid-19 6Os by three resear chers Willia
asse tP . . m
The caPitalhn Lintner and Jan Mossm indep enden tly. Conse quent ly, the mode l is .
often
~ed. Jo Sharpe -Lintn er-Mo ssin Capita l Asset Pricm g Mode l.
eferre to as . .
r\:\':
r The capital asset pricing model ?r CAPM _ is _really an exte1:1-s10n ?f the portfo lio theory \'I\
f Markowitz. The portfol io theory is a descn pt10n of how ration al invest
ors shoul d build .\I
~cient portfolios and select the optim al portfo lio. The capita l asset pricin
g mode l derive s
the relationship betwee n the expec ted return and risk of indivi dual
securi ties and portfo lios
in the capital market s if everyo ne behav ed in the way the portfo
lio theory sugge sted. fl
Let us, therefore, begin by summ arisin g the funda menta l notion s of
portfo lio theory .
ml
I
FUNDAMENTAL NOT IONS OF POR TFO LIO THE ORY

~eturn and risk are two impor tant charac teristi cs of every invest ment.
Invest ors base their
mveshnent decision on the expec ted return and risk of invest ments .
th Risk is measu red by
e ~ t y in returns . •;, V [J._;.__,1· n, Y ::, 0 <
1}-0\-4 ~ t70f,vJ~
ThisInvest0rs attempt to reduce the variab ility of return s throug h divers ificati on
results c ti' of invest ment.
portfolios m ain the _ r~ - 0 ~ o f a portf oho. . . . f . .
With a given set o_ secu! ihes, any numb er_ o f
Among thes/ ~ tr~ate d by alter~ ? t~e ~ropo rtio~ of funds invest ~~ in each
securi ty._
majority 0f p ohos some aomin ate otn:e-rs - orsom e are more efficie nt than the
portfolios be vast
set of portfolio s cause o f 1ower risk or highe ' · t
r return s. Invest ors identi·fy th.is e ff.icien
Dive 'f• ·
b rs1 ication hel
~ orne risk fre If ps to reduc e risk, but even a well divers ified portfo lio .
that __does not
· _ ::7ould be e. th ·-We cons t ruct a portfo lio includ ing- a:U fhe securit - -- - - - - k ket
cons1d~ ~ most ct· · · i_e_
~ irr_ the sto~ ~,
s
or 8 erable v a r i a ~ ~ r ifi~-9- _J?ortf olio. Even such a portfo lio · - -- b t to
Ystem t· ity. This va ·
_woukL e SU b. _j _~c .-
-----=------ a 1c risk b -~ 1 b ·1· ·-.- - - - -- -· - ---=~ the market risk
----- -~, uecaus e it ff a i ity is undiv ersifia ble and is known as .\"
. . . .,.,~~ - - - ---- a ects all ,._
____________ securi
the. ·___ _ ties in the marke t .
~ 1~
I,
. ":,Q
 r
I '-
. and portfolio Management
'
198 Security Ana Iys1s . Capital Asset Pricing Model (CAPM) 199

. k f a security is the market risk which c"n- . t a riskless asset available for investment. A riskless
The real ns O tl: • • . ~•«ot b re exis s
. . . ·on This is in9ic.9-te_d _b-}L- ie_sensiti.\illy.: of a secUrity e elitni hat th e . .
. such as a government secunty. Smee the return is
diversificahd . · ~ asured by the beta coefficient o ~ ty to the rn. t\ilteq ed t · certain . . .
rket an is me OVe lh . 55of1l return is . k is zero. The mvestor can invest a portion of his funds
ma . al ;.--vestor would expect the return on a security to. b ll\e~,.1¾., · 15 a
vJ 1t
1,-,ose
e w • ·u·= of re
turn or ns l ct· h · k
Aration u• 1
ld be equivalent to en mg at t e ns free asset' s rate of
Th hi her the risk of a secunty, t h e hi g h er would be th ecornrn.e"" "'~I*~ r-l 0 et 1·s ,..,e
·
. of'I ,vari·abi t•1whlC · h wou
h ·
be investing · a comb.ma t·1On o f ns · k free asset and
nsk e g . • •t m
· . th elevant risk of a secunty 1s i s mar k et risk or s e reh•u.rn
- '"'ll
ex t<1te , I asS . ,_..
' rtai!I, . ,.1ess a 5 ue wou
se ld t en
And smce e r . . . k nl Th
ected to be correlated with this ns o y.
. stern ti
e capital asset
Peet "11~ .
_a _ c: risk eq ~~-1~
,e. tile risJUaf'(lel1 Rt r> .
d that an investor may borrow at the same nsk free rate for
11
~ fth relationship between the ~ pected return andthe·~ tn.o~ tehlt\ \ ~etllff'I' :ets- . ay be assurne f lio of risky assets: He would then\be using his own funds
natureo e - - - - - - - ~ rna_tic:~ -'~ • ~" as 1t i:ri. . a port o
-
/ ASSUMPTIONS OF CAPM
~f.~~ ris i5iff'lilarl'f, investing in nds for investment.
rpose of 1:,orrowed ~ .
. .
frorn a feasible set of portfolios of nsky assets is concave
I.

, 1~

\ weP:11 as s_ ~e t frontier ans~g assurned to use riskless lending and borrowing in his
0
The capital asset pricing model is based on certain explicit assurn . as virile efficien an inve stO r i~ the efficient frontier transforms into a straight line. Let us
behaviour of investors. The assumptions are listed below: Ptions regiltd· a e. Wh~n. the shape o
ill sll p t activity . . .
1· Investors make their investment decisions on the basis f . lt\g ~i . vestrnen . }'lappens, cave curve ABC represents an efficient frontier of risky
measured m .
2. The purchase or sale o f a secunty
. 1
.
.
b
O
terms of expecte d returns and standard d nsk- . . return as
can e undertaken inev1ation of retu_Sesslh...
u u ·. . "~
il'e 1low
se
thi5
·der
fig 15.1 - The contfoli·o in the efficient frontier with RP = 15 per cent and
Co~ 51 B is the optirn
05
· · al por . . .
t with rate of return Rt= 7 per cent 1S available for uwestment.
\\
3 Purchases an d sa1es b y a smg e mves t or cannot affect~:,----..~ I.Ititel d"IVisibl!'tis. · nt. A risk free ~s~e of this asset would be zero because it is a riskless asset.
· f · · h · P0 rtfoliper ce
there is per ect competition w ere investors in total d Prices
t . · "US Ille e..:'\
'T'l., u,,:,
<Jp"' 8. or 5tandar
d deviation .
d n the y axis. The investor may len d a part of his .
money at

\
• e ermm . ¾s ~ 0
actions. e Prices by . Tile ris\ would be p_lotte . the risk free asset and invest the remaining portion of his
4. There are no transaction costs. Given the fact that transacti ~ »erce, 1 t i e invest 1n
the riskless ~akye, p~~tfolio.
they are probably of minor importance in investment decision::ac~sts ate ~ funds in ans
they are ignored. king, ilnd~
s. There are no personal income taxes. Alternatively, the tax y
•
income and capital gams • h
are t e same, thereby making the inrates on div~
Vestor induf
.
R,,
----c
0 the form in which t h e return on t h e investment is received (d' . ~at
Portfolio
capital gains). ividends 1 re turn
6. The investor can lend or borrow any amount of funds desired at a rat .
equa1 to t h e rate f or ns · kl ess securities.
· • eofm1in1
7. The investor can sell short any amount of any shares.
8. Investors share homogeneity of expectations. This implies that investors Nll
identical expectations with regard to the decision period and decision inpu'!
Investors are presumed to have identical holding periods and also idenfQ
expectations regarding expected returns, variances of expected returns l!l
covariances of all pairs of securities. A

It is true that many of the above assumptions are untenable. However, theydo m
materially alter the real world. Moreover, the model describes the risk return relati~
and the pricing of assets fairly well.
O ' - - - - - - - - - - -- - - - - - - - - - - - x
Portfolio nsk -<Tr
Fig. 15.1 Efficient frontier with introduction of lending.
EFFICIENT FRONTIER WITH RISKLESS LENDING
AND BORROWING lfanin. ves t or P l aces 40 per cent of his funds in the riskfree asset and the remauung
·· 60
:n,e portfolio theory deals with portfolios of risky assets . According to the _theory,~ ~:~c:ent m portfolio B, the return and risk of this combined portfolio O' may be calculated
g the following formulas .
mve stO r faces an efficient frontier containing the set of efficient portfolios of nsky a¢
f (I -------- ~"'!111"'·1 f
200 Security Analysis and Portfolio Management
' ~i - Capital Asset Pricing Model (CAPM) 201
Return
. k of such a levered portfolio can be calculated
and r1s as follows:
Re = OJRm + (1 - OJ)Rt
where 'fl1e retllfl1 RL == wRm - (r.o - l)Rf
Re= Expected return on the combined portfolio. I·
OJ= Proportio n of funds invested in risky portfolio. the Jevered portfolio. \,\
(1 - OJ) = Proportio n of funds invested in riskless asset. ii~~ ~ J<et1Jl1' ~:n of investor's ~ds invested in the risky portfoli0
~'.' \ I
R,,, = Expected return on risky portfolio. ~. proportl the
~ risky portfoho. ·
()} ,
~ rn on
J<etu. 1' free .
borrowin g rate w hi ch would be the same
R1 = Rate of return on riskless asset. as the .
Risk ~, ,i,e"' elY the retum on the riskless asset. ru;k &ee lendU,g
C1e = (J)(Jm + (1 - 0J)C11
rin o
I rate, naJll e equation represent s the gross return
. earned b • .
where jl,e ,rst te well" f th ;r,vestor's own funds m the risky porttoli Th Y mvesting th, \'\
O"e = Standard deviation of the combined portfolio. ..,ed fu!lds as ents the cost of borrowin g funds which is dedo. e second term of
.. rro"' . epres ucted fr
OJ = Proportio n of funds invested in risky portfolio. "' "1"'''" r . the pet retum oP the leve<ed portfolio. om the gross
O"m = Standard deviation of risky portfolio. tli~.rl!S to obtaLf\h levered portfolio can be calculated as:
C1t = Standard deviation of riskless asset. retu''f}le
·- ns· 1' of t e <Yi = OX1m
The second term on the right hand side of the equation, (1 _ co)o: 'f}le return and risk of the investor in our illustration may be ca1culated assuming
= zero. Hence, the formula may be reduced as '.f Wouid be Zer
Oas ()),. 1.25 RL = (1.25)(15) - (0.25)(7)
o,
O"e = OX1,.
= 17 per cent
The return and risk of the combined portfolio in our illustration •
is Worked C1L = (1.25)(8)
Re = (0.60)(15) + (0.40)(7) out be\o-,,: = 10 per cent
= 11.8 per cent
and risk of the levered portfolio are larg~r ~an those o~ the risky portfolio.
O"e = (0.60) (8) = 4.8 per cent The return f lio would give increased returns with increased nsk. The return and
Both return and risk are lower than those of the risky portfolio B. n,e levered portdo ortfolios would lie in a straight line to the right of the risky portfolio
If we change the
. k of all [evere P
proportio n of investme nt in the risky ns . . depicted in Fig. 15.2.
75 per cent, the return and risk of the combined portfolio may be 8. fhiSlS
calcuiai~rlfo lio lo
below: as sho~l y
Re = (0.75)(15) + (0.25)(7) I
Rp
= 13 per cent ii
O"e = (0.75)(8) = 6 per cent -----c
Here again, both return and risk are lower than those of the risky ,portfolio B.
Similarly, the return and risk of all possible combinations of the riskless asset and II!
risky portfolio B may be worked out. All these points will lie in the straight line &om
Rt to B in Fig. 15.1.
Now, let us consider borrowing funds by the investor for investing in the riskyportfooi
an amount which is larger than his own funds. Rr
If OJ is the proportio n of investor's fund~ invested in the risky portfolio, then wecin
envisage three situations. If OJ = l, the investor's funds are fully committed to the rislj
portfolio. If OJ < 1, only a fraction of the funds is invested in the risky portfolio and !Ir A
0- - - - - - - - - - - - - - - - - - x
Gp
remainder is lend at the risk free rate. If OJ> 1, it means the investor is borrowing at the rs
I
free rate and investing an amount larger than his own funds in the risky portfolio.
Fig. 15.2 Efficient frontier with borrowing and lending.
.-J~
 ~· -- - --
r,r" -~ .--", \
"""-:_I
202 Security Analysis and Portfolio Management
. . ''- I'- {-'>-~ Capital Asset Pricing Mode/ (CAPM)
'"f"'
I
Thus the introduction of borrowing and lending inves . turn relationship and a )Jleasure of risk for effi . -
' . . o· us an ff·
•ght line throughout. This lme sets out all the alternat· e tcieht .,j(ies a risk ~ek for an efficient portfolio is the standard de ~e~t portfolios. \ I
str a1 . . 1ve co . ·• fr ,,ro• of os . b . v1ation of return
o B with risk free borrowmg and lending. ll1b1nat· 0ntie
po rtfoli . •on tth ct/41: r 111eas~re . ear relationship ~~een the nsk as measured b the st
The line segment from Rf to B mcludes all the combinar s or tL •t~ 'file priate 'f}lere 1s a lin turn for these efficient portfolios.
0
Y andard I'
,:\ I 1
. tb d . 'le . i
\,\ I
ions of th e risk ~ll
the risk free asset. The lme segmen eyon pomt B represe 111eaP!:r1folid·o~i,e e"pected re ~ ' ; )/
(that is combinations of the risky portfolio with borrowing) Bnts all the I YPoru . 1 ' of tl1e ~oil 11!1 \~ j- ...---, ,,-_. , '1\ \
0 0
expected return and the nsk, · wh'l
.
· combinm
1 e lend'mg (that 1s, h ing ihever ec1 ho11 0ah,
' · rrow·
g t e . k ••Crea r ttf ·~ Jeviat1 ff ~KET LINE ~/ { qJ)ri J . 'i \
I \'.1 : l
free asset) reduces the expected return and nsk. Thus the . rts y Po Ses b o\i,
. . ' invest rtfo\· 0th " k sicVJU turn relationship for all efficient portfolios. Th~ uld . \ 'I l,
lending to attain the desued nsk level. Those investors w·th 1
or _can Us 101yi t~
. · f · I "1 II
hold a combmahon o nsky assets d 1
a h h riske bo tro1y•lh K
g ·~l ;(.t't ws tile risk-~e All portfolios other than the efficient ones will lie\ all lie
Prefer to lend and thus,
· ill b d· line- d .b th . k e1ow the
with less risk aversion w orrow an mvest more in the an the rtsk
risk · free av ersio1nn~o~ CML 5i,o.tal rnar ket C" "L does not escn e e ns -_return relationship of . ffi .
f~e cap! 'f}le lVl • aJ . . lne Ctent
· Y Portfolio. asSet. () ~ti\ 11 tJ,e ,, t [ine- cun'ties. Toe cap1t asset pncmg model specifies the relati hi
¾,, aloflo 11r,.e . .dua 1se 11 .ti. d 11 f ons p
·1al tJl f jr1d1Vl d risk for a secun es an a port olios whether eff .
,aP1 uos or o d return an ' 1c1ent or 1;
/ THE CAPITAL MARKET LINE ortfo expecte . ,,1 , \
rerweeri . th t the tot<!_! risk of a security as measured by standard de . ti' •·,1
All investors are assumed. t? have i~entical_ (homogeneous) ex . v . ·erit. arber a . .k d . . via on q,
iJleff~c1 ve seen e - onents: systematic ns an unsystematic nsk or diversifi bl ,,
them will face the same efficient frontier depicted in Fig. lS E pectattons. Ii we hll f twO comp ~ d .. a e
ed O • d ....,..- :rsffiea and more an more securities are added to a portfolio th 1\
combine the same ns · h d'ff
· ky portfoli o B wit ·2· very in Vestor ence
1 erent levels of lend. .,,. 'a\\ ~ J11P 05 · - t 15 ive -- - 11 d' ifi. d f li - ' e
1 111 ~%iiive5~en_ reduc~d. For a v__ery w_e ive(s . e . port o ·o,.:uns_)'.stematic risk teng_s ,,1 ~
to his desired level of risk. Because all investors hold the same~ -g t borrowing Seek ~ risk• ----maticflsk is_,.- ~relevant y risk_lS systematic nsk measured by beta (/J). Hence •t
include all risky securities in the market. This portfolio of all ris~s YP0 r~f?lio, t~;c~rd~! ~ yste --ana . h r' . k . b /1 1ri '. \
w~ . [l'fe zero
tne O t measure of a secun,, s ns 1s eta.
as the market portfolio M. Each security will be held in the pro y s~cunties is refn 11 w~ fob'1'CO t the correc - - - --,----..,;-----,-- !;t
portion hi err!\I ••ed that u~ th xpected retum ot a secunty or ot a portfolio should be related to
value of the security bears to the total market value of all risky se . . w ch the ~ ;, ar~ at me e"t'___ d b /3 ·
. . . . cunties · h in,~-- /it follows ·ty or portfolio as measure y . Beta 1s a measure of the security's
mvestors will hold combmations of olily two assets, the market 1'.' t emark ''11 :I 11
nsk of that seCU1'. market return. Beta value greater than one indicates higher sensitivity
1.
. portfolio and et ~ the t changes in th . d' ~·1 I
security. a tis~ sen5itivity O hereas beta value less an one m 1eates lower sensitivity to market
All these combinations will lie along the straight line repres . oJllarket changales, wof one indicates that the securi m te and m · I ,:I ~ I
t
frontier. This line formed by the action of all investors mixing the ma kenting the effici ;hanges. ~ ~ as the mark-et-. Thus, the /3 of th mMket ma be taken as one ,!1 ~
I 'I r et portf li ,n1 ~ direchon ·
risk free asset is known as the capital market line (CML). All efficient O 0_wi~ ~ the sallle . hip between expected return and /3 of a security can be determined !,j
investors will lie along this capital market line. portfoliosof~ The relahons h h ,. d ·I
. ll !3,!..JJs consider an XY graJ> w ere expecte returns are plotted on the y axjs I 1
The relationship between the return and risk of any efficient portfolio graphica Y· ef~cients are plotted on the X axis. A risk free asset has an expected return 111
market line can be expressed in the form of the following equation. on thecapi~ r
~ f o cfbeta coef~ent o ~ Ifie mar~et po_rtfo~~ ~ has a beta coefficient ~
~ '
an expecte return eqmvalent to R.n A straight line JOllllilg these two points is
~n as the secunty market lin~ SML. ·s_ is ill~strated in Fig.)5'3~
~
Re = Rf + [ R,,, - Rf a 1
(] 111 e ~security market ~e_pro_v1des ~1:._relationship between the' expected retum-and
beta a securi or -_ar.t~ . This relationship can be expresse~ e form o~ll:re'
where the subscript e denotes an efficient portfolio. lo ·owing equation: - - -- - - -- -·"
f - - 7, j
The risk free re~ Rf represents the reward for waiting. It is, in other words, theprici ii
(R
3;..:..
=_R__;_;_=_ R,!r___+.....:/...:
1
...:"::... U-
' _- _R_,_r.:... ' I
of time. The term [(Rm - Rnlaml represents the price of risk or risk premium,i.e. tfi I
excess return earned per unit of risk or standard deviation. It measures the additioNI A part of the return on any security or portfolio is a reward for bearing risk and the
rest is the reward for waiting, representing the time value of money. The risk free rate, R1 fl I
return for an additional unit of risk. When the risk of the efficient portfolio, ae, is multipliro I
with this term, we get the risk premium available for the particular efficient portfolio (which is earned by a security which has no risk) is the reward for waiting. The reward
under consideration. for bear~g risk is the risk pr~mium. The risk premium of a security is directly proportional
Thus, the expected return on an efficient portfolio is: ~sl.cas...m.ea~y j/3)',!'te risk premium of a security is calculated as the propucf"
of beta an~ the ~ premilim-·~!. the market which is the excess of expected market return
(Expected return) = (Price of time) + (Price of risk) (Amount of risk) over the nsk free return, that is:l'Rm~ ,]. lhus, _L_;c:r----- __
jl
I
I Expected return on a security = Risk free return +' (~tax Risk premium~ l ' ,:,
___ ,,,;,,(.~.:
 Capita l Asset Pricing Model (CAPM) 2.0S
204 security Analysis and Portfolio Management
urity Q is
y .. ,rn of\ sec - _ + 1.6 (15 - 6)
drew R- - 6
Expected ..,ecte ' :::: 6 + 14.4
return ~
e e~r
::::W A~re cl
has an expec ted return of 12.3 per cent whereas securit
yQ
. a ~ of 0. 7 hi her expec ted re~ of 20:4 p:r
. p ~,ritl'l f 1 .6 has a th g most impo rtant discov enes
cent.
m the field of finance lt
\
se'\Jriti er beta ots one of e ll assets and portfo lios
/4
M
~ . \I 3 1'i_S, represented return for af any two assets
of assets in the economy
can be related to the dilference ~ th/
Th
,1t fl"'
1
we
cA e)(l'ec ecte d re turns~o atic ris~ . e On1l}'..J.IDP
. .
Or:l:<!I)lIDgredient in determining u
I &fibe5 iJ'I tile e~~.1 ates__that sys efunin ate all unsys temat
ic risk throug h divers ification
dJif{e! e!'~l _Acl
eoS..""
11 111e !!!CJ',! AS if\ves tors can
warde . g_sys
d only for beann tematic . . k Th
ns . us, the relevant risk,
~ d re~ · ted to be re . k. and not the total nsk.
r -eete
e-'P 3fl oe e)(fee . systerna
tic ns
\) .u•. eyc se t is 1ts
of all
35
p
/. ~0 c~L .th CML Both postu late a linear (straight line) relationship
'\
OU - - - - - - - - - t - 1 - - - - --
;S!Jl, to contraSt ~
. eeess~1 and re.wrn - _
511
isk is defin ed as total risk and is measured by
1n M_l.. the risk is defin ed as system atic nsk and is measu
1.0
2.0
It I
b~ ~
r1s" ~
atiof\, -~
hile in 5
d only for effici ent portfolios w hile secun·ty marke
- --,-~.- --
t line
red by
is valid
\
Beta ~ e arket lifle is :ad . ·dual secur ities as well. CML
1
Fig. 15.3 Security market line. 1tal Ill d all is the basis of the capital market
in 1v1 . .
P tfo\ios an . of the capita l asset pncm g mo d el .
~
1lor
all por . SML is the basis
wtule
/4MM theOry
\
f Toe relatio nship betwe en risk and return establ SECURITIES WIT H CAPM
ished by the security k . I
~ s the capital asset _pricing mode l. It is ~asically pRIClNG Of . .
a simpl e linear rel:~ ~~line is ~o~~ odel can also be use d f or evaluatin
· g the pnan
· · g o f secun· · Th
ties. e
the value of beta, highe r would be the nsk of the The capital a_sset pr~: ~:or k for asses sing wheth er
th . secur ity and there£ p. The h1g1iei a secur ity is underpriced, overpriced or
e return expec ted by the invest ors. In other word ore, 1arger U,PM provides a din t CAPM each securi ty is expected
s, all securities are e Would ~ to provide a return commensurate
return s comm ensur ate with their riskin ess as measu . ed Accor g O
red by /3. This relati x:ct~d to ~e~ co~ ypnc ~frisk . A secur ity m' . e!)' be off~. g -~,.,, .-o h , rn c: th
~,_,,_,__..an_~
only for indivi dual securities, but is also valid for all
Th portfolios whether ef:~ p 1~ validnot with ~ ti' e On the contr ary, anoth er _ecte.d ,ietu.ID ,
secur ity~
e expec ted return on any secun' ty or portfo lio can aent or meffi ·~ ~ it more attrac v . . -
.
be offenng less return than
be determ ined fr ~ ~ d turn makin g it less attrac tive. -
formu la if we know the beta of that secur ity or
portfo lio. To illustrate th/; ~AP},\it ~E:cte re d ' turn on a secur ity canb e calcu
lated using the CAPM formula. Let us
the CAPM, let us consi der a sirnp~e exam ple._There
value s of beta as 0.7 and 1.6 respec tively . The nsk
th k
are two securities p
free rate is assum ed to be 6
!X ~a~~ The
~ expect
- eth retheore tical -retur n. The-
designate 1t as e
i~
-
real rate of return estim
in a securi ty can be calcu lated_~)". the follow . f
·
ated to b e realised from
l
.
e mar et return _IS expec ted to be 15 per cent, per cent g ing ormu a:
thus provi ding a market risk pre and •
of 9 per cent (i.e. R,,, _ R.r)- (P1 -P0 )+D1
llllum
The expec ted return on secur ity P may be work R; = P.
ed out as show n below: 0

where
R; = R1 + /3;[Rm- Rr1 P0 = Current mark et price .
= 6 + 0.7 (15 - 6) P1= Estimated mark et price after one year.
= 6 + 6.3 = 12.3 per cent D1 = Anticipated divid end for the year .
This may be desig nated as the estim ated return .
 - - - :tilliii.2~
206 Security Analysis and Portfolio Management Capital Asset Pricing Model (CAPM) 207

The CAPM framework for evaluation of pricing of s urity market line, securities that plot b
. the sec
they offer a higher return than that a ove the rme
ecunties te"t of ·
Fig. 15.4. coll use
can be ii . d beca . . expected fr
. the de,.,.,nce O the other hand, a security is presumably . om
h1s1r ifl tJJ1 •r . k n .d overpriced if 1·t
y •teq .r"i15, are f1le ns · . . estimated to prov1 e a lower return than th
1" i,IY .1,,e sa e 1t 1s .. . at expect
Estimated "'111 vfl,~ witll v• L becaus . k class. Securities which plot on SML are assu d ed I\
return pre>je5 w tile ~~he same ns text of CAPM. These securities are offering reU: . tol_be
,e' pelO .. es i!l ill the coll s m me
J_;./V 101s cllr1tl iced
C V P..
• rfr0 !11 ser1a. ielY. ,,,11.es
pr s·
ff the se
curity market line would be evidence of rnispnc· .
B Sl,,jl . . d . mg m the
nroP ·r risJV>· t...;.,g o d to identify underpnce and overpnced securitie
A
• ,rr tt,el plO \l>' be use
,it11 rities AfM call . calculated accor mg to
d' CAP .
If h
s. t e
Cr> M is lower than the actu l
• 11 ,o1:1J
unty
,.,- ,..,1ace- ll a sec th t security, the secunty . . b . a or
w111 e considered to be underp . d
~el r f1l o d by a
111ar cted ·retll r!1 offere . will be considered to be overpriced . nee .
when the expected return
R (YV"'A ~pe ied retll a 5ecunty CAPM formulation is higher than the actual return offered b I
Q • e,~111a o11trarY, rdi!lg to
the c 0·1y acco y
I
h
Rf p • ontJ,e 5ecll le. The estimated rates of return and beta coefficients of some
• on clJrilY. .der all exarnP
the se co11s . 1 below:
I I

Let 1)5 e as given

•ties ar
seeorl ~ Estimated returns Beta

-----
5ec11rihj (per cent)
30 1.6
A 24 1.4
0.7 1.00 1.3 X B
2.0 18 1.2
Beta C
15 0.9
Fig. 15.4 CAPM and security valuation. D
15 1.1
E
12 0.7
Figure 15.4 shows the security market line. Beta values are plotted on th F
.
estimated returns are plotted on the Y axis. Nine securities are plotted e XaxIS, w~
t of return is 10 per cent; while the market return is expected to be
according to their beta values and estimated return values. on the giai\ The risk free ra e
Securities A, L and P are in the same risk class having an identical beta val 18 per cent. CAPM to determine which of these securities are correctly priced. For this
The security market line shows the expected return for each level of risk. Securi~e ofo.1. We can usel late the expected return on each security using the CAPM equation.
on the SML indicating that the estimated return and , eJ<~ecl_re.tu.rn__ n sec~i:,PIOll 1 we have to ca cu . l.1
0
identical. Security A plots above the SML indicating that its estimated r e t u ~ R; = Rr + /3;(R,,, - R1) I
its theoretical return. It is offering higher return than what is commensurate with its risl
Hence, it is attractive and is presumed to be underpriced. Stock P which plots belowfri Given that Rt= 10 and R,,, = 18
SML has an estimated return which is lower than its theoretical or expected return.Ths · The equation becomes
makes it undesirable. The security may be considered to be overpriced. R; = 10 + /3; (18 - 10)
Securities B, M and Q constitute a set of securities in the same risk class. Securi~ i
may be assumed to be underpriced because it offers more return than expected, whilf The expected return on security A can be calculated by substituting the beta value of
security Q may be assumed to be overpriced as it offers lower return than that expectid security A in the equation. Thus,
on the basis of its risk. Security M can be considered to be correctly priced as it provid~
a return commensurate with its risk.
R; = 10 + 1.6 (18 - 10)
Securities C, N and R constitute another set of securities belonging to the same risl = 10 + 12.8
class, each having a beta value of 1.3. It can be seen that security C is underpriced,securi~ = 22.8 per cent
R is overpriced and security N is correctly priced.
208 Security Analysis and Portfolio Management
Q/ ~ • .
orrectly priced, we ne
'...J r curitY is c ...:..-r'\ated return on t1
• :1. r a se (b) the esuv •
Similarly, the expected return on each security can be calcul vvhethe formula, olding period.
ssess cAPM ver the h
value of each security in the equation. ated by substitunn ,ro a 5 per . price o
The expected return according to CAPM formula and th glhe1,.. 1 · rt f!\ a ettl )
. e estirn -~ 111t10 d ,etv :-,creas rv R r - Rf
security are tabulated below: ated retu ~o eete d v- r11 - Rf + ,-,1, n
l'I\ of ea~ ei-1.de!\d alld rett-1 Ri - 115 (12 - 5)
Security
01vipi:Fecte :::: 5 + · _ _05 per cent
Expected return
~ · 1
5 imated :::: 5 + 8 .05 - 13
(CAPM)
- - - - - - - - - -- _ _:_return
A
B
22.8
?- d retilrfl -:---:-7 l >f,--i;-
~ j~
21.2
24 ...,ate
C 19.6 pstl""

~
18
D 17.2
15
E 18.8
15
F 15.6 12 : : : ~

5
Securities A and B provide more return than the expected return and hen 3 .8 -10.85 _ 0 1307::: 13.07
assumed to be underpriced. Securities C, D, E and F may be assumed to be ovce ~ay be ::: 7+
~ -
-83- - .
each of them provides lower return compared to the expected return. erpnced
as . . more or less e
In this chapter we have seen two equations representing risk return relationshi non the security is
fir~t _of these w~s the capital market line whic~ describes ~e risk r~turn relation:~-~~
efficient portfolios. The second was the security market hne descnbing the risk r~tuin
A.s the estlmabted
· can e a
:::~:ed as fairly priced.
t you as por,
'
the secunty . d ta are available o

----
relationship for all portfolios as well as individual securities. This formula is also kno 3 The followmg a
as the capital asset pricing model or CAPM. It postulates that every security is ex~ ExamP Ie Stan
Beta
to earn a return commensurate with its risk as measured by beta. CAPM establishes a Estimated
linear relationship between the expected return and systematic risk of all assets. This Sewrity return (per cent )
relation can be used to evaluate the pricing of assets. 2 .0
30
-A 1.5
25
SOLVED EXAMPLES B 1.0
20
C 0 .8
Example 1 Security J has a beta of 0.75 while security K has a beta of 1.45. Calculate the D
11.5
0.5
expected return for these securities, assuming that the risk free rate is 5 per cent and the E
10.0
1.0
expected return of the market is 14 per cent.

1
15
Market index 0
7
Solution The expected return can ~e calculated_us_ing.S"~ _ Govt. security
1
. which o
Ji·{i = Rr + /3i(Rw - R1 ) I ?~1-P O,f~ r ~ tf\ the security mar k et 1me,
(a) In terms o f
For security J - (: I J,-JJ/,f'-- D, ~ underpriced?
;...,g that a portfolio is constructe d
d usiJ:
R; = 5 + 0.75 (14 - 5) (b) Assum 1
-" · ecte r
securities listed above, calculate t1:le exp
= 5 + 6.75 = 11.75 per cent
For security K Solution . . f th ecurit
Ri = 5 + 1.45 (14 - 5) (a) We can use CAPM to detenrune which o ach es
seclll
we have to calculate the expected return on e
=5 + 13.05 = 18.05 ·per cent
l 2 A security pays a dividend of ~ 3.85 and sells currently at ~ 83. The securi~ R, = R r + /3i(Rm -
Examp e d t 11 at~ 90 at the end of the year. The security has a beta of 1.15. The risk
· expecte O se
is . ·
t and the expected return on market index -''-el
is 12 per cent Assess wheu•
ovt. security return rate) = 7 anc
free rate is 5 per cen . .
thesecun
· ty is correctly priced.
A
 Portfolio Evaluation 235
com bin ati on
gro up of sec uri tie s. It is a
. agg reg ati on of a ran do m .f. of
eh oiv- ~ 1. v;ezl' sunp 1e d . so as to red uce the ris k
ll, the . .-1111 ,o bin e m a spe c1 1c wa y
Por tfo 1, 1tlvesl ,f'i'''' . is 1,ot a d sec uri· tt·es , com eva lua te the per for ma nce
of the
l fo
1 1
10
inv est or ma y att em pt to
.~ror,{llJI Y seJecte . im um . An hin
lll)
-llO Of
~ll ce of his secllti .~I ind ivi du al sec uri tie s wit
nin g the per for ma nce of
'will Portr01 . ties. il c;1r\ent to the rrunwith ou t exa mi h f 1· .
whole val uat ion fro m t e po rt o 10 vie w. .
1 0!1
e11ab1e h/'oiii 11·t'slJl
i1 _. ; JiO as a
fl-l o
. .
. This 1s e at the tra nsa cti on lev el,
or the sec uri ty lev el,
11:1
1il
lli lo tio n ma y be att em pte d me nt is an
I'° 0 rtfob0· d oft en mi sle adi ng . Inv est \
t~e ~ot1gh ~v al~ oul d be
inc om ple te, ina deq uat e an sid er
act ivi ty mu st, the ref ore , con
·. ttfo lio s •···u. lua tio n of the inv est me nt i.1
,uch ev~Jt1at1~ns risk. Pro per eva the po rtfo lio lev el and no
t at I I
""141 cj ·f t ris k is bes t def ine d at
llla y be e. . ,_ l ferent ;ctivity J.l'lvolv~~ risk inv olv ed. Bu t per spe cti ve for eva lua
tio n is the
"·•d~St_eq lo
. esf:n-ie11t
. lnv retufll aJ~ng l:v el or tra nsa
cti on lev el. He nce , the bes
i on , the or a e:Isions we secuntr . I! I
folio view II It
Pa re the Pe ~ ttisiltion port
orll'lilnce
ALUATION
I
~ IN G OF PO RT FO LI O EV I.:
lio. It is I
per for ma nce of _the J:'ortfo
to the eva lua tio n of the ret urn
:oni.Pa.n.ies Operc1tin Portfolio eva lua tio n ref ers on a por tfo lio wi th the
par ing the ret urn ear ned lua tio n
)et e With each Othe; essentially the pro ces s of com ark por tfo lio . Po rtfo lio eva
por tfo lio s or on a ben chm
1er org ani sat ion s b eamed on one or mo re oth er rem ent and per for ma nce
eva lua tio n.
ctio ns, per for ma nce me asu ned on
lid ity . Inv esto rs ilnl essentially com pri ses two fun ich me asu res the ret urn ear
an acc oun tin g fun cti on wh
wo uJc t like to know Performance me asu rem ent is . Per for ma nce eva lua tio n,
on the
per iod or inv est me nt per iod
fun d or inveshnent a portfolio dur ing the ho ldi ng for ma nce wa s sup eri or or
inf eri or,
iss ues as wh eth er the per
tnd the ir portfolios other han d, add res ses suc h .
s du e to ski ll or luc k, etc
whether the per for ma nce wa ret urn ear ned on the -po rtfo
lio has
ma nce of a por tfo lio , the
While eva lua tin g the per for th tha t por tfo lio . On e app
roa ch
t of the ris k ass oci ate d wi
to be eva lua ted in the con tex cla sse s an d the n com par
e ret urn s of
lio s int o equ iva len t ris k cif ica lly
would be to gro up por tfo app roa ch wo uld be to spe
cat ego ry. An alt ern ati ve
portfolios wit hin eac h ris k by dev elo pin g ris k adj ust
ed ret urn
ris kin ess of the por tfo lio
p of the portfolio adjust the ret urn for the dif fer ing ris k lev els .
eva lua tin g por tfo lio s acr oss
~veral transactions measures and use the se for
1ri ties . Hence, the
Measuring Po rtf oli o Re tur n ned ov er the
:h as a transactions of the rat e of ret urn ear
eva lua tio n is cal cul ati on the por tfo lio
The first ste p in por tfo lio cha nge s in the val ue of
y be def ine d to inc lud e the cas e of
holding per iod . Re tur n ma the per iod . Ho we ver , in
s any inc om e ear ned ov er als
over the hol din g per iod plu
ho ldi ng per iod , cas h inf low
s int o the fun d and cas h wi
thd raw
in thi s
Ii .;
sale of securities. mu tua l fun ds, du rin g the be use d to cal cul ate ret urn I
e uni t-v alu e me tho d ma y ,I
·ds its correctness from the fun d ma y occ ur. Th I ,I
nge
case. ma y the n be def ine d as the cha
urn, r, for a mu tua l fun d pe r un it
I i
Th e on e per iod rat e of ret cas h dis bu rse me nts (D) and 1 ·_: I
ue (NA V), plu s its pe r un it
in the per un it net ass et val . It ma y be cal cul ate d as: ;; Ji
s (C) suc h as bo nu s sha res ' I,
cap ital gai ns dis bur sem ent } ~ j : 11
pri ce. At the end (NA Vt - NA ½_1 ) + Dt +
Ct I '
I:,
R =
w er than its cost P NA ½-i '1 /
div ide nd might f ' ;, r:/
t
i'
to evaluate the ! '/
J,) [
:ur ity viewpoint. ~!' t
· - --- -·- - - -
 236 Sec1Jrity
vd,crc
-------
Anafys,s and Portfoho Managemenr
NA' ', = i\lAV per unit at the end of the holding period.

----. .. ._
------........
\
\ I
.\'A, ', _1 = NAV per unit at the beginning of the holding period
D, = Cash disbursements per unit during the holdin :
. . . . g Period.
c, = Capitalgams disbursements per urut during the holdin
T1m fonnuJa gives the holding period yield or rate of return e g Perioc1.
may be expressed as a percentage. arnect 0n a Portfolj
The rate of return earned bY different mutual funds or mutual f 0·1h1s
calculated and compared with. .; ( llnd s h
the rate of return earned by a repres . c ernes rn
index which can be used as a benchmark tor · comparative evaluatioen~hve
Th stock rn~' Lb~
n. ell'\.llt\1,11 fllnd
may also be ranked in descending order of their rates of return. But such 1
•r~,1
.
rate5 of return comparison may be mcomp
. le te and sometimes even st raight
. fonva .s
11
d'ff 1ng. l'n~,
differential return earned by mutual ftmds could be due entirely to thern1sleact·
.
exposure of the fund s. Hence, the returns have to be adjusted for risk befo I erenr1aIris
comparison . re lllakinganr1
Risk Adjusted Returns
One ~bvious me~hod of a~ju~ting fo_r risk is to loo~ at the reward per unit of risk. W
that mvestment m shares 1s nsky. Risk free rate of interest is the return that a . eknow
. kl ess security,
. 1.e.
. wit
. h out beanng
. any ns . k. The return n investor
earn on ans earned over d can
the risk free rate is the risk premium that is the reward for bearing risk.
· · 1s
premium · d 1·v1·d ed by a measure of ns
· k, we ge t thens· k premmm
· per unit of risk.isThnsk
1;~/b~ve
the reward per unit of risk for different portfolios or mutual funds may be calculated a~~
the funds may be ranked in descending order of the_ ratio. A higher ratio indicates better
performance.
Two methods of measuring the reward per unit of risk have been proposed by William
Sharpe and Jack Treynor respectively in their pioneering work on evaluation of portfolio
performance.
lsharpe Ra'f] .
¼ e performance measure developed by William Sharpe is referred to as the Sharpe raho
or the reward to variability ratio. It is the ratio of the reward or risk premium to th1
variability of return or risk as measured by the standard deviation of return. The form~a
for calculating Sharp1e ratio may be stated as:
\
. rP - r f , ~ . ( , l<\\ ,
Sharpe ratio (SR) = ~ VoJ.A!JJJ''i ;, ~
~ ,
...,.,J -
w he re . . \- 1;.. .1., \_ 'r,
r P = Reahsed return on the portfolio. . ,.
r1 = Risk free rate of return. I ~7 11 •J • __.,.,,.
<JP = Standard deviation of portfolio return."
~ \
~~ i ,\
 ~c
C;,,,wr Ra,t;-:j
Por tfoli o EV8IU8tfon 237
sur e d e'\_e lop ed b,·
, Tack Tre yno r is rrfe rred
·h" per farman<.e me a . r . to . 1 s Tn• yno r rt1ti o or
, Ttv rati o t .
15 the rati o o f U1e re\v.:ird 0r n~k pre
miu
p
n~uI aoJ
m astamc vola he<l
awr b b}. t ,;0- ro rt/o ho bel.! . The form ul,1 for ca Icu I,1Hngm -rrcy
to the vol,ltility o f
nor ratio ma y
be t,,t:,ted a<.:
',, - rf
Tre yno r rati o (TR) = 7fr =\
wh'1'C r..:.!-1 ~ vola. 1-,·1 - ,.
r =- RcJ hsed retu rn o n tie J tf 1·
por o10 . ~/ · I ll /{
;(
_('1 slc»'d f7' c
I: '"' Ri!, k free rate of re tur n.
f l, l(J j,l
/Ji _ 1--ort folio bet a. .
P TO u nd. er:,
. --t"
" nd the cal cul atio n of the two rati os let us con.sid er an example. The
(lf1d ri:-ik (,
,gu re~. o( two mu tua l retu rn
fun ds and the sto ck ma rke t md ex are giv en in the table
.
F11"'I Return (per cent)
Standard deviation (per cent)
Beta
t1 12
18
z 19 0.7
25
.M (Ma rket ind ex) 15 1.3
20
1.0
The risk free rate of ret urn is 7 per cen
t.
The Sharpe ratios for the thr ee fun ds
are:
12 - 7
A= = 0.277
18
19 - 7
z= 25 =0.48
15 - 7
M= -- = 0.40
As per Sharpe's performa nce me asu re, fund Z has performed better than the benchmark
market index, while fund A has per for me d wo rse than the rnarket index.
The Treynor ratios for the three funds are
:
A = l ~ _;
7
= 7.14
Z = l ~ ,;
7
= 9.23 I
!
1 7 I
M = ;_~ = 8.00 I
fu dAccording tO Treynor ,s performance me
I\
n A has pe f asure also, fun d z has performed better and
r ormed worse than the benchmark -
.
r;, ·
I
I
I

238 Security Analysis and Portfolio Management

Both the ratios are relative measures of performance because the
risk involved. However, they differ in the measure of risk used for relate the retu l A"
value of a,,
.,egati"e 1<et or a rar
ier;/· f the
piar
ill Jensen
n
the total risk as measured by standard deviation, while Treynor empl: Pll.rpose. Shall\ to the ,tl'~ tpat o }'la value . tical xnetl
as measured by the beta coefficient. In a fully diversified portfolio Y8 the systemrp~llses t11af',r1,e alP b)' statlS have a
would be diversified away and the re1evant measure , a11 uns anc ' P' f 1,er 0 could
of risk would b th Ysternati tis~ ~111e o ·al retufll ·stical sense.
For such a portfolio, Treynor ratio · wo uld b h e t e appropriate mea e e beta coef~c.r'ts~ ~•ffereflt1 iJ1 a stab -'- ,.,ds A an<
evaluation. For a portfolio that is not so well diversified, the Sharpe ra~~ _of Perforll\:l\t. vi erO ·def l'-"".
froitl i ,,s co11s1 cent respec
1 et,.,
measure would be the appropriate performance measure. smg the total~~ . ., ~11d 19 per . 5 per ce.
erit iv· f1l 1s 1
per c r1<et rettl turn on the
""IFFEREN TIAL RETURN {Je.AS e,,f\,.'_s J! ,z.,,b0j . rtte f!la "pected re
'[he e (R ) ::::: 7 + o.7(1
dA E P
Another type of risk adjusted performance measure has been developed b Mi filfl : E(R ) ::::: 7 + 1.3 (
and is referred to as the Jensen measure or ratio. This ratio attempts\o
ftlfld z. P ~
chaelJensen . turn or c:
differential between the actual return earned on a portfolio and the return measUre the 'fhe differenha1 re ~
the portfolio given its level of risk. expected froll\ _ 12 - 12.6 -
d A: a,, -_ 19 :.._ ·
i The CAPM model is_used to calculate ~he e~pected return on a portfolio. It . .
the return that a portfolio should earn for its given level of risk The di'ffe indicates
fuf\
fund Z: a,, -
17.4 =
. · rence b tw
the return actually earned on a portfolio and the return expected from the f e. een The negative value of alph
I i
measure of the excess return or differential return that has been earned over olio is
is mandated for its level of systematic risk. The differential return gives an indicatiovewhat
an~:~ a The pos1
·h·ve value of alpha fc
bly due to the supen
.
portfolio manager's predictive ability or managerial skills. presurna
onofthe
,l Using the CAPM model, the expected return of the portfolio can be calculated
follows:
il
It
as ~COMPOS ITION OF
E(Rp) = Rt + /3p (R,,, - R1)
The performance measures d :
where
II E(Rp) = Expected portfolio return. c,/
/!
(

, >I =- ('
..;vf~&t pe..zi
,, ~
~" ~-
or fund. Eugene Fama has
breakdown of a fund's perfo:
R1 = Risk free rate. is known as the Fama decom
Rm = Return on market index. [··
.::' :;:.:: j f'\ ~r_.A..,1'. 19-1 V The total return on a port
free return and the excess r e
/3p = Systematic risk of the portfolio.
,.... r✓ 1l) ~-:::._ r'\WJrr ol
Total r e
The differential return is calculated as fq_J,ktw.s:___
7
where
~RP - E(R~ J __.,- The excess
stock selection.
return
Hence
arises
the exc
namely ri k premium
s • or re,
a,,= Differential return earned. as return f
rom stock selecti
RP = Actual return earned on the portfolio.
Excess return=
E(Rp) = Expected return. The risk of
I f .
I risk. When a sec~nty is o f
,I Thus, a,,
represents the difference between actual return •and expected return, If ,,IL has
ent
a positive value, it indicates that superior return has been earned due to superior ~anag~ger
skills. When a,,
= 0, it indicates neutral performance. It means that the portfolio m:hold

risk w
the risk

a portfolio of sec·
1 ct·
OUd
Portfolio Wo isappear. But,
u~d have both s
has done just as well as an unmanaged randomly selected portfolio with a buy an sy premium
ii ,/1 stemat· .
ic risk (
can be d
/;•
Risk market risk
~ Premium -
- Return for
-<~_ji~:~
 -~~te tq ~
u ie Purp ose SJ, "1 to fl,
ploy s the sYst ilrii. ~
, ~~
-:,:-.~
'
.... ··~-
I
Portfolio · Evaluation 239
io, a)) Uns:vst ell\aij, 'is\ ~ I \ \
strate gy. A negative value of a,, indica tes that
:I he the hetq ::•ij, 'is\
the
than that of the marke t or a rando mly selected portfo
portf~ lio's per~ormance has been worse
lio of equiv alent risk.
1easu re of Pe fefficiel'lt The alpha value in Jensen measu re can be tested for its degre e of significance from a f
· Using t Ot1n
ratio value of zero by statistical metho ds. This means
th -•1<ltlce· , an analy st can determ ine wheth er the
differential return could have occur red by chance or
e total lisk from zero in a statistical sense.
wheth er it is significantly different
j Let us consi der funds A and Z. The actual return s realis
per cent and 19 per cent respec tively with ~eta coeffi
The marke t return is 15 per cent and the nsk free rate
cie~ts
ed from the two funds are
being 12
0.7 and 1.3 respectively . I
1s 7 per cent. \
The expec ted return on the two funds can be calcul ated I
as shown below: !
•ped by Michael J I
Fund A : E(Rp) = 7 + 0.7(15 - 7) = 12.6
empt s to ensen
the rneasu,. Fund Z: E(Rp) = 7 + 1.3 (15 - 7) = 17.4
· retur n e"Pecteq fro,,,
The differ ential return or _alpha value is show n below
:
portf olio. It indicates Fund A: CXp = 12 - 12:6 = -0.6
1e diffe rence between fund Z: CXp = 19 :_ 17.4 = 1.6
rom the portfolio is a
l over and above what The negative value of alpha for fund A indicates that
its performance has been inferior.
The positive value of alpha f?r fund Z indicates_ that i~s perfor
~s an indication of the presumably due to the supenor management skills of its portfo
manc e has been superior,
lio managers.
can be calculated as
~CO MPO SIT ION OF PERFORMANCE
The performance measures discussed so far assess the overall
performance of a portfolio
or fund. Eugene Fama has provided an analytical framework
that allows a detailed
,'"'.Y / r~ pe..t}'~1t breakdown of a fund's performance into the source or comp
onents of performance. This
is known as the Fama decomposition of total return .
f
; ;? )
'
0-·-f I/ The total return on a portfolio can be firstly divided into two
.,
components, namely risk
free return and the excess return. Thus,
; }' i:c }.} y
Total return = Risk free return + Excess return
The excess return arises from different factors or sources,
such as risk bearing and
stock selection. Hence the excess return, in turn, may be decom
posed into two components,
namely risk premium or reward for bearing risk and return
from stock selection known
as return from stock selectivity. Thus,
Excess return= Risk prem ium + Return from stock selection
. The risk of a security is of two types: systematic risk and unsys
tematic risk or ~vers~able
r~sk. When a portfolio of securities is created, most of the unsys
tematic risk or diversifiable
nsk would disappear. But in pract ice no portf olio woul d be fully
!d returI1· If ap has · f · divers ified. Hence , a
. port oho would have both 'systematic risk ' · 'fi bl
,erior ma!la
geJtlent the risk •
and a small amount of diverS I a e ns· k· Hence
.
,
premmm can be decomposed into two components, name ly return for bearmg
oortfolio (lla~a~ systematic risk (market risk) and retur n for bearing diversifiable risk.
i:, a bt1Y a~d hO : Risk re . .
ThuS, . . .
P mium = Return for bearing systematic . r bearing divers1f1able nsk
nsk + Return fo
 240 Security Analysis and Portfolio Management
....-.positio:!l
n,u s, thl' 1-01:il return on o portfolio can be decomposed into four corn 's cteco..-
Return on portfolio = Risk.less rate + Return from market risk Pon~nts -" f.i/11.i
+ Return from diversifiable risk
+ Return from pure selectivity
This may be represented as:
RP = Rt + R1 + R2 + R3
Each component can be calculated. The risk free rate of return (R) is the
on a riskless asset such as the government security. f return avail
The return from market risk (R 1) is calculated as: ab1,
R1 = /3p (R,,, - R_r)
where 111us,
R,,, = Return on the market index. Alternatively, f atn<
farna's
The return from diversifiable risk (R 2) is calculated as:
R2 = [(o-p/ 0-
111 ) - /3p] (R,,, - R1)
where
err = Portfolio standard deviation.
The return from r
O"m = Standard deviation of the market index.
realised on a portfoli<
The return from pure selectivity (R3) can be obtained as the difference between the indicates that, due to ·
actual return and the sum of the other three components as: . from it conunensurat
The decornpositi<
R3 = RP - (Rf + R1 + R2)
.. li!
in active portfolio Ill<'
The return from pure selectivity is really the additional return obtained by a portfolio than the market reh:
manager for his superior stock selection ability. It is the return earned over and above the ability to achieve th•
return mandated by the total risk of the portfolio as measured by standard deviation. would be positive.
Mathematically, this can be calculated as the difference between the actual return on a Portfolio evalua1
portfolio and the return mandated by its total risk. This is also known as It provides a mech.
Fania's net selectivity measure. The following formula may be used for calculating the measUie. improving the defi
Fama's net selectivity = RP - [Rf+ (ap/ am) (Rm - Rf)l mechanism for imp
where
RP = Actual return on portfolio.
Rf= risk free rate. Example l An im
Rm = return on market index. cent annual return.
O"p = standard deviation of portfolio return. return and the ma
O'm = standard deviation of market index return. How would you E
The Tn
Solution
We ca~ illustrate Fama decomposition of portfolio return using the following data on a case.
portfolio.
RP= 21% (JP= 15%
Treyno
R,,, = 16%
<1m = 12%
Rf= 10% /3p = 0.85
r...,
-~
~
,'t-,
~~/~::. I\
~
,
Portfolio Evaluation 241
as:
~ o s i t i o n may be stated
faina s e
RP = Rf + R1 + R2 + R3
Rt = 10%
R1 = fip(Rm - R1)
= 0.85(16 - 10) = 5.1 %
R2 = [ ( ap/ am) - fip] (Rm - R1)
= [(15/12) - 0.85] (16 - 10)
= (1.25 - 0.85) (6) = 2.4%
R3 = 21 - (10 + 5.1 + 2.4) = 3.5%
Thus, RP = 10 + 5.1 + 2.4 + 3.5 = 21 %
as fol low s:
ivi ty can be dir ect ly cal cul ate d
Alternatively, Fa ma 's ne t sel ect
f+ (ap/am) (Rm - R1)J
Fam a's net sel ect ivi ty= RP - [R
= 21 - [10 + (15/12) (16 - 10)
)
= 21 - (10 + 7.5) = 3.5%
wh en the act ual ret urn
ma y be neg ati ve. Th is occ urs
The ret urn from net selectivity k of the por tfo lio . Th is
n tha t ma nd ate d by the tot al ris
realised on a portfolio is less tha ear ned the ret urn exp ect ed
selection, the por tfo lio has no t
indicates that, du e to po or sto ck
al risk.
from it com me nsu rat e wi th its tot ent skills inv olv ed
is use ful in ide nti fyi ng the dif fer
The decomposition of tot al ret urn to ear n a hig her ret urn
por tfo lio ma nag er wh o att em pts
in active portfolio ma nag em ent . A eri or sto ck sel ect ion
her ris k an d dep end s on his sup
than the ma rke t ret urn ass um es hig urn du e to pu re sel ect ivi ty
urn . If he is suc ces sfu l, the ret
. ability to achieve the hig her ret
would be positive. tfo lio ma nag em ent .
cycle of activities com pri sin g por
Portfolio evaluation com ple tes the est me nt pro ces s an d for
nti fyi ng we akn ess es in the inv
~t provides a mechanism for ide uld ser ve as a fee dba ck
Th us, por tfo lio eva lua tio n wo
unproving the deficient areas.
tfo lio ma nag em ent process.
mechanism for im pro vin g the por
SOLVED EXAMPLES
has pro du ced 16.8 per
tfo lio tha t ove r the las t five yea rs
,xample 1 An investor ow ns a por a. Fu rth er, the risk free
e the por tfo lio pro du ced a 1.10 bet
cent annual return. During tha t tim yea r respectively.
th 7.4 pe r cen t and 15.2 pe r cen t per
m and e market ret urn ave rag ed .
would you eva1uat e the per for ma nce of the portfolio? f Ii · thi
, .
of the po rt o O m · s
ution The Treynor rati·o can be use d to eva lua te the per for ma nce
Treynor ratio (TR) for the por tfo
lio = /3p 'r
rP -
16.8 - 7.4 _ 9 .4 = 8.55
= 1.10 - 1.1
..,, ~---
 Sha re Valuation 101
--; ::a mp le, if an investor expects to get
hare during the ~ext three years an~ hopes to
~ 3.50, ~ 4 and ~ 4.50 as dividend from
sell it off at~ 75 at the end of the third
a 5 and if his required rate of return 1s 25 per \,
\·
year, cent, the present value of this share to the
an be calculated as follows: I'
investor c
3.50 4.00 75
- -1+ - - -2 + -4.50
s0 = -(1.2
5) - - 3
+ - -- 1\ \'
(1.25) (1.25) (1.25)3
\\
= 2.80 + 2.56 + 2.30 + 38.40
\
= t 46.06 \I

~ .\
In order to use the present value model for sha \

•t'
re valuation, the investor has to forecast
the future dividends as well as the selling pric
e of the share at the end of his holding \
eriod. It is not possible to forecast these variable
kfeasible. Modifications of this model have bee
s accurately. Hence, this model is practically \
n developed to ren der it useful for practical
purposes of stock valuation.
In the case of most equity shares, the div ide nd
per share grows because of the growth
in earnings of a company. In other wor
ds, equity div ide nds grow and are not con
over time. The growth rate pat tern of equity stant
div ide nds hav e to be estimated. Different
assumptions about the growth rate patterns can
be made and incorporated into the valuation
models. Two assumptions tha t are commonly
use d are:
1. Dividends grow at a constant rate in
future, i.e. the con stan t gro wth assumption.
2. Dividends grow at varying rates in futu
re, i.e. mu ltip le gro wth ass um ptio n.
These two assumptions give rise to two modifi
ed versions of the pre sen t val ue mo del
of share valuation: (a) Con stan t gro wth model,
and (b) Multiple gro wth mo del .

CONSTANT GR OW TH MO DE L
In this model it is ass um ed tha t div ide nds wil
l grow at the sam e rate (g) into the indefinite
future and that the disc oun t rate (k) is gre
ater tha n the div ide nd gro wth rate (g). By
applying the growth rate (g) to the cur ren t
div ide nd (D 0), the div ide nd expected to be
received after one year (D ) can be calculat
1 ed as:
D1 = Do(l + g)1
The dividend expected to be received afte
r two years, thre e yea rs, etc. can also be
calculated from the cur ren t div ide nd as:

D2 = Do(l + g) 2
D3 = Do(l + g) 3
Dn = Do(l + gt
The present val ue mo del for sha re val uat ion
ma y now be wri tten as:

S = D0 (1 + g)1 + D0 (1 + g)2 + ... + D0 (1 +

0 g)"
(1 + k)1 (1 + k) 2
(1 + k)"
 102 Sec urity Ana lysis and Por tfolio
Man age men t

Wh en ·,1 · a ppr oac h es in fin ity, th is fo rmu la can be s imp

lifie d as: - The j_ntriflsi c v alu e of th

S0
_ D1
- --
D0 (1 + g) fl•""
N,
the now frof f\ per
'' (al infi
or nity, refe rred t<
k- g k- g 1 10
Thu s , acc ord in g to this m ode l, th e intr insic valu
. .d d b
exp ected d '.. v 1.d en d d 1v e o f a s har e is equ al to next ,
1 e y the d1· f fe re n ce betw een the app year s
The gro wth rates dur in
stoc k and its exp ecte d d iv id e nd rop riat e disc oun t rate for the
gro w th rate. frorn year to yea r. Hen ce, t
The con s tan t gro wth m o d el is a be forecas t ind iv idu ally . T
lso kno wn as Gor don 's sha re valu
afte r th e m o d e l's o ri g ina tor , My atio n model, named
ron J. Go rd o n . Thi s is one of the for this firs t pha se , usi ng tl
wi d e ly u sed m o d els bec a u se mos t well-known and
of its sim plic i ty. The mod el doe
s not requ ire forecasts of phase. Then
futu re di v id e nd s an d futu re sell
ing pric e of the sha re. All that
div id e nd g row th ra te assu mp the mod el requires is a
ti o n a nd a disc o unt rate . Bot h
wi th o ut mu ch d iffic ult y . Th e of thes e can be estimated
g row th ra te ma y be es tim ated
di v id e nd s a nd ea rnin gs. T h e di from pas t grow th rates of
sco unt rate is the inve s tor' s req This ma y be sum marise d
is so m ew h a t s ubj ective a nd wo uire d rate of return which
uld d epe nd upo n the inv esto r's
opp o rtun itie s a n d hi s p e rcep tio alte rnat ive investment
n o f ri s k invo lved in pur cha sing
To illu s tra te the app lica ti o n o f Gor don the sha re.
sha re valu atio n mod el, let us con side
A com pa n y h as d ecla re d a di,·id r an example.
end o f~ 2.50 per sha re for the cur
has bee n fo llow ing a p o lic~· of enh ren t yea r, The compan_y The sec ond pha se pr
anc ing its div iden ds by 10 per cen
exp ect·e d to con tinm• this poli cy t eve ry year and 15 grow th mo del , bec aus e t
in the futu re also . An inve stor
p urc has e o f the s h a res of thi s who is considering the phase . The pos itio n of t
com pan ~ has a requ ired rate of
The intr ins ic y a ]ue of the co mp retu rn of 15 per cent. can be vie wed as a poi
a n y s sha re can be calc ulat ed as:
periods N + 1, N + 2, N +
Ol1 (l + g ) - < 2.50 (1.10) - 2.75 divi den ds wo uld be:
So = k - g - 0. 15 - 0.10 - 0.05

= < 55
. Id be ad vised to pur chase the sha
T he in ves to r wo u ' re if the cur ren t mar ket pric e is lowe
r
tha n ~ 55.
,1nd so on to infi nity .
i ht' pre sen t val u
MU LT IPL E GR OW TH MO DE L ~ +- lto infinity can be
The
. . con
. stan t g ro wth 11
d1v 1de um
. p tio n not. be rc,11. in m,m y soh
nds ma y be a .t ass
vor y1n ~ rat<"may · . A typoca l s1tu istic 111,m y
,1tio n fur . . . . cum t , .
a per 10d of ext rao . rdin . ' inns . Tlw S, h>1' . ·ti I II•,
a ' C1 ' . '
' ter whi ch gro wthry g row th (e1tlw r ~"" '' or ~.1<11 .w ill 11n· v•,11 (nr <II ,1t11
will d 1,.1n~e tu ,1 (tt w l .11w t•s nm, · 1, l' ti I;,t
. h1d1 11 .' " ,•x,,
' ,.,.11 •' 11 '"·@ llm rt,,l
, ,n num . . t,t•t·
· ' ,i lt may be not ed th
Thi s situ atio n can be rep rese nted
Years af , by ". two ·••~ g• gro wth •~•oML ~ivi
. th• futu re tim e period is v,cw cd ,IS d1 v«i1'11• inh> iw o
11 ' ind, •ho itd)' · leraden
' ·ds fro m tim e p
n t 1s moc .e ·t· , I xtraordinary· ..
l
,, row lh pcn.u•:l ,1nd th<' sub sequ lll'r , it mu st be dis c
. ' . 1 1 . enl en . . ent g rowth ~has
seg me
I nts h. the ,n1 ,a . e. • I erio d groO w th rntes will b• v,1m
1ble strea.....
e div. ide nd stre am .
•
from y,•, gro wth 1
per iod . Du rtn f; the in,t ,a .Pd th• • , , '" " ' ' Viewed at 'ze
g row th rate will rem ain con stant frum
'•" · whi
ro
dur ing the sub •sequent pcno .
N 1 le
inv
. esto r has to fore ·t the t,m e u plo which ~rowth rates wool d lw .,,.,,
1 . The
cas 1.1 be co11
· ·· ·"" " st.in 1•1. -his· wnu
. ,h,•r
ld 111ca n th,1t the pre><'"' nd1d• fthe
<' nn<' ph,ISC wou Id 1 ,1'1 unl1.1 lnf '"'
 ..,,. . . , ~
.
Portfo lio Selec tion ,a,
r I ' ,_ inves to, ~ ,o u \d n ot be inteTe s\ed
. ,a:;cie nt p ortfo
\cf' o w ·n as oPH'Jr
rturu· tv
, set . H e\ios. ~-
woul d be intem If
ted o nly m \\,e • ,aein n
I

14 \iOS llre·n t-h e opP

✓
1

,<I<>
...o 10 \iOS '

PO RT Fo uo SELEcnor-..i ,:;,,,- I""

,,, "' ,,._.,uoh••. ficien \ pe<tfo:~"'; . . \et uscu ns· id« van· o u s com.b
,· Th• exp= ted '"'~; ::' ~ y ,,,.,.
i.natio{ns\ o{.
po,\ o ,o,
;.,-'''·est• m easu, ins th,
' inc co ""1"
5<1 q{ <>I •~ Po"f o\ios ',,fol ios
1
th~,rn i.\ f th.e:.e po m ay
b\e bdow besh o •s'.'~
w s us\rn live figum lo, the
~111'' ,,.,,. ,.:dc>ilV'a';-.,, n, k ;<.,,,m>•1"-\':"om• pO<tlolios .
c,t<Vµflt1eS
-<o '-e "'aJ' "cd
· a ti Of'
1 o ul.f
d nortf
t a.n olido d cvuH ioru, o
9 - - - -~ =~~ de1Jin1tim1
• r• or ... o ,- dar
•11'3 ydiJfd Stnnd nrd deu1nt1 on
~ tJf1ce tCd de"
" re
~turf\ S an !Jpt'ci.<':d '""'"
t)
lpcr un IR,skJ
--
c<!' tfol•o no
ro• - f,
~
The objec tive of eve,y cabo nal im•es to, is 4.5
to m ax;,n ise his 'Vtu,n ,; •na 1 7 -.,
D;ve ,sific a tion is the m eth od a dopt ,-d foe 58
ced u cin g cisk, It '-"'""n h,:;". "'~"' L',, 2
~2 7 .6
ronst cocti on of pottfo Hos. The Pn:>pe, goa I
portf olio that p,ovi des the high e,;1 cetum
of poctfolio cons tn,cti on n-
and the lo"·<-st cis k_ Suc1, a po,u, ~"" '•,
• •: ,a'i.:"" \ 0 .5
\1 .7
8 .1
8 .1
knowolio
portf n asselec
the opUm
tion. al portf olio. The Proc ess of findi ng the Optim 0 0 1
a I J>o<tlolio ~;""'-, UA 9.3
, ..,.,,
n.s 9.5
The conce ptual h-a_n,ewo, k and ana lytica l n.s
1-ools fo , _deten ninin g the op'"" '"""" ' 78 11 .3
in disci pline d and objec tive maru ,-, ha ve \5 7
_been p,m-,de_d by I-fan-,- " " " ' - • "'- 12.7
pione e,ing wo,k on poctf obo •naly s,s desc
nbed m his 1902 /oun, a/
subse quen t hook ' in 1959_ 1-fis meth od of po,tf of'"'""",...._, 12.':l
as mode
Ma,k rn portf
owitz
ofio selec tion has com, lo be""°"• ..: •
modeolio
l. Iotheor
fact,y.
Ma,k owit z's wo,k mad,s the heg,n rnng of
what is kn"'""' 10
16.t!
lhe sam e stan d ar d ..
. .
d e v1ati on o I Bl .
po<t!ol\o
nt than pmtf o\io no. 4
I lie
mpart> port o tedn os.
• and 5\I
, IOT . .' \ mo, e elhn e ,etum o I l3 5 pe, cent,.
FEA slBL E SET OF POR TFO LIO S - we
H -,-e,;.
co highe r expe porctfOu
,etu m ol
"o n os . 7 and
·5
7 malting. t d
Im lhe same exp ec e • ellid ent than pmt Io \i .
o
rtfo\ .io
. no. 7 . mak ing·uttbe
~
mor gm' d e d by two crite na:
no- ' "'-,

secu,i□es
we comp
Again. id rd de,·iaare tion_is \owe f p<ortfol
lo< iO'S po b . lhe \nve s\mdw,
h• stan a se\ec t,on o r e turn, the .mvestor woul d pcele ,

pcopo,□
With a limited numb ec of me expe cte
an inve sto, can neat e a vecy lacge nomb ec 1 . th
of portfu];,, tno. 8. Thus , the -
by comb
oppo ining
rtuni these secu,-ities in di ffecent
ty set. ons. Thes e const i tu le the feasible "' 0 GiYen " ' ·o . po rtfoli os .,...; th. ,_
th \o,•,e r ns-"· the s.a
. . k lhe .mv es tor wou \.
d prefe r the one w1
J>ortlolios in Which the inves to, can possi bly . w,lh e . '" lhe same ns ,
inves t. This is also know n as the portfuli, the one . k
tlo\io s ~,u, -
- . 1 d a\so ns -
Each VOrtfolio in the oppo ,tuni ty set is chaca 2. G>Ye h - po,
n two expe cted retur n. . lhat \nve s tocs a,e r ation a Asanthey ace ns . k
mea,
Portfou,. lio of •isk, viz., va,ia nce o, stand acd devia tionct,-,L
oppor
sed by an exp ected cetum ,nd •
o f .-etu ,ns_ Not eve,y po,tfolio in the
the hig. "'
. e b ased on lhe assu mpb on tum to less cetum
tu.-.;ty t · 0 f · .

a~~ can;;:;
. . These crite na a, . . I lhev w o uld pre . oce , e fe, m
Will - obv1o 0
. u.s1y be"'d se· " b ortfolios d
mtec estto an mves to, . In h The expec te
:::t-.... a lowe r s t and ard devia the oppo ,tun, ty set . • hP 'ther
some avense. As they
"'>na ted Ythotl,e,s_ A poctf ofio wi ll dom inate
f d les,.'risk lo mor e ns~ d wilh the help
fr.:'I';,-.. a n o the, •,fh,t as" led af;'~ ;ph, meas uc\n1
. _' :~~' -•..,'\:~
tu,-,, .•nd th nd•n
•on e S.U.e expe cted cetuc n as lhe o thoc, o, a h,g averse , they w otl of i~\Ci ~nt ~ts can bef~
The conce p l_u s'::: n be depi cted on 01 an the X axis. F\gu ,e \4.
-.r:;
· ~, .,.., "'~- . . .
:-~ ~.: ~ ' "'"' Sla .,d devia tion as the e, •'I"' . ,tio n ol po,t o ,os
othe ,_ Poctf olios Iha, ace dominat\'d by telurn and stand acd de,,. ' y ax\s
d devi ation on
.. .- :s..""!l-
:-"~ .,. ,.
' -
,. - -
,, .
_ and the s tand a,
olios has an
·:~. ~ ~~~-
., . .... . \ ' • '-.Ji#
' _''\\ ' ~~ ,- 0 the expec ted «,tum on the
~~ ~ ~...
~
,,·~ ~ depicA~ ts each
su eh poss . , · port_1 r in lhe o ppor
• g•mnh leasi ble sel ol poet\~ wou\ d be
i, ,- , k~V t .-.~ ~- .:(:> · ty_ setd or
cxpec t~d retur n 1b\e
a n s a o io d . tion asso tuni ciate with it, each Portlo '°
~' t"'.
' .
~
- r;J'\.f'
,
,
. _-.. ..:. ~ .,. ~,,. - ~:·~ -
-~ ........~&.' , ..-~
J

"'' ✓
......-"
'
_
·' '
\
.

. t...-4,
if
... ""-.
, .,: \. • • -~

\~·
.
'·-~
, ~. ·1•• -,:...;_•
-~'I,,'<
-
• •

~
~•'·
,.,. *; ::-, ,...:-. ·~··
....
~- J . t ,.t. -.A ... . . ... . . -.;.:'i ,.. .:,,. ,~ .I:,,.•'.~":•\, ·,,
.. ~- ~. ,
t ndar d dev1 a
 ~
Porttouo ~e 1e i;1 1u •, • ...,...,
18 2 Se cu rit y An al
co nc av ys is 8" d PM fo f;o
reer
prfeestle :t e d fr om
en te dap bye abe ca. usaegi·tve n e gr ap h re p, -, se nt
:r e enclosed,
gr ap
be co h. Th e sh adesi ng le po in
se t ofMse ancu
agri·
em ti·een t ;:c e se t of al l w ·
/ O
Le cns llcoclrros
t yus elel d ar
atyed ea t in th thin th 0 0
po rt f li w ,
it h in
•ea th
co
ch ns
otishe e .
ns k-
tsr of pore tus,
rt fo m Th
lio
ex am in
,
s co
is nto ~~ ~r tu nipo 1
ty ssseibt lefpor
e tfo
lwoliaxes ()f
""""e se t of po rtf 1\0S \y U 'g be tw ee
.-tfo\i· <' tb e ,.
.-. th e ef fi gl ob al ,n itW "u m va
P o os ha ve th e th e di ag ra
mmg o p "' " ""
, i''""" 't'/ ,e_,t-a>
" 'i'' "' "' re tuff
r<ci
ci en t fr on tie r <i 'Ce
re nr esafen ts
\

w ou ld b , -, U" ot'o at'd thfe.. ' e<

pO't• {tot>tier ,.
is sb oW " se pa
ortfo\iOS· '{ he e ra te ly "
,- k e pr ef er e sa m e ex p Se curltie 1 , ' F ,g , 1'
' -2 -
,s , bu t po rt fo re d t ec m ,n Fi g 14 1
lio E o pm tf ol te d re tu rn b , , , C on si s
Ottfo\' ""
that '"" "' "-
"'.,,1• t set o ?
i;,;:~rred to po df
io F, N ow ut po rt fo lio E d a,e I .. _ ,,, & fp
o m ov e as f ol ioo~e-,-:i,m or e re tu rn ~~ ~; her pm tf ol io ,,.. ~• "
po ss ib le in th
le ft in se a, ch e , ar
, us , fo r
as po ss ib le in
;" 'e ct io n of de ';;?
;:
e
er
sa
po in t in th e ,
po
m
,tf
e
ol
,
io s" ' / " tisk, s
an d E B
;:d E, "' ~ •
\lo,, •
ce p ••~
,,

cr ea , e di re ct io ns k, en ce , ot
n of _ns k- re tuHm

~
o de cr ea si ng
Y
E" J'e ct, d
ds k .;: :;: g ns k,
- up Ef
w ar ds in fe ct iv .::
se ary,
'c re as in g
chhe
retu:
ofw, ou ld be m ov
h ha~
si :a portfolio ,' '" "' -;
U,. ""
an in v, .;: ," ""
an d also • ..,.
m cr ea si n g retum '
rn "i
~
gs.taw ards the
•

0
f\ g. '\4 .2 1"he
ef f\c \e nt fro nt
\e r.
Th• ef lic i• "' t,o
,;t ie t is a cot>ca
ve cu<Ve UC' tb
..;nun= va d• "" ' e ri sk « "- '" ' sp
po dl o\ io to tb ac e th at extet>
e rn ax in "u n" re ds {t or n th e
-" po rt fo lio -
sELECTION o
The portfolio v o l' T l} ,{ ,\ L p o
se le ct io n pr ob le R
m is re al ly th eT v o L IO
pr oc es s of de \;n
ea tin g th e ef fic ie nt Po
0
St an da rd de vi thenRa setio
lectna
inlgmthveestbe
orst rt fo\ io s ., ,d
ati on X sw poillrtob vi oufrslom
fo lio
partlolio th at •" y prthefeer to
se t. ;,, ve st UC' th e ,f f\
Fig. 14.1 in di vi du al in ve ci en t po rtf ol io s-
F ea si bl e se t of portfolio •' in ve st ot 's de gr st or w il l se le ct 'fb e pa rt ic ul at
s ee ol av er si on {r or n th e ef fi de
, L et us co ns id e- on the lo w er le to ri sk , A hi t> t f<Ot>tiet will
ft ba f'd se gm en gh de pe t> d on
'.'
C of
m ,thfe
e rs
di, le
agr am , po
m th ,s ch agr am rt fo
1o?
ss ds k , or tf _
e ol
thliosacmioessle
Cthanl dofArePo
ve O
th
ns k av et se w ill
'fb e selectiOho
t of tb e ef fi ci en
ly ,i sk av er se
t ft on tie r, w hi
;n ve st or w ill no
le •" in ve st or
\d • po rt fo lio
ha
re pr es en ts th
tu~rt fo lio C w
- In th e op oupoldrtbe pr
, n olldtho,e;eop 01> th e up pe t
tu = \ po rt fo lipo rt w bO is t>Ot to o
e lo w es t ns k co un ityef er re d t p0 ttf . k o tb io <' of th e ef fi de t> t ftot>
b C om pa ri ng m pa re d to al l ot se ol io .. er an ce . ib is ca us de pe nd s 01 tie r
po ttf ol io s A a:
l: .o h t of po ttf ol io A _ ,. . coshnvo erse.ly ,,,.on hi n be gr an hi ca \\y > th ,
e ;n ve st ot 's ds
k av et si on , or
ec au b al "' .in im um s representol s r\ sk es t 0 lor m ilf er en re nr es en te d th
th e pose ,t liof fe ts hi gh er
rt fo o w it h th e ~e tu
variance po :~ tr
tf ol
ns re tu
w'--w'ch rn un ht y cu rv , ce cu<Ves- 'f be ;,, ro ug h a se ri es
o
rn h fo r th'ew e fi nd th at io s, Here partfolio n m ri g. 4.3. Ea, · e re difle re t> C' cu rv es
T hus ch cu rvd.

td
, w e fi, nd th at g es t ex pe sa m e le ve l of po pr es e1 >t s of al ' u, ve st-or
risttf
k. ol
In iothB ,
i idis. '°-
pr ef er ab le to po
th e su cc es si ve1
n • t ,
fe r
di f ret>t co m bm an r at fe
m or e ef fi ci en po rt ct
- ed ," ' tum rernp• » ar e eq · on s of ns
t th an al l th e fo lio rtfolio A ua11yr sa' tis ry O t e co1>ce · · k and .,e tu r"

~
m s famct oth
s ly m g m th e am on g al l th e spo rt•g fora, m' po m , hi s ut ili f e tcu
, rv n> ed in ve st
h e: 'Cca <h su cc es si o< - 'f be in ve st ot is o
al l f
th e sh ad ed ar
ea is ca lle d th
eP O
E; ~oc,lio
no rt h w es t bo un d th t B
lio s m th e feas;b
,e p ,- • ,
- 0 - ev e sa tis fa on or uh ,ty , wve cu<Ve m ov in g up ;,, di f{ et el 't be tw
w ar ds ee n
enst m
Fronth etiemr te le set m g up ct i
1 1 Oto • bi gb et ut ili ·1· e ;n ve st or ' s go al to u,
~l- . e l en
bedo
ca<usof
e ty cu rv ,r\. .,
e- 'f be op ti m a\ w ou ld be to mao rn,se
lof
alam eTh
th e, ef fish
is
oe·ad
boed
nt poar
un ea
rtfry
da olare
ioofs th po rt fo lio fo r at> <i •
;,, ve st• or
 ~
184 Sec urity Ana lysis and Port
folio Man age me~ t
Portfolio Selection 1aS
wou ld be the one at the poi nt of
util ity or indi ffer enc e curv e. tang enc y betw een the effi .
k wit z mod el is the com
h the Ma t O uxnerous and complexplexity of computations
I ,
Thi s is sho wn in Fig. 14.3. The cien t frontier ~ . ltY ·••it
poi nt O' rep rese nts the v•
diffiCU . s req uire .. d are n in nature. With a given \ I
l,
. ci his tis f li s can be con stru cted . The expe
ecotld ft\Putationrnb et of por t O ~ol cted retu
io hav e to be computed. The identificrns and
O
Ptill \al p t t~
y OrtfoJ.io. '(fled~ 'fll~ co ~te nu ch pos sibl e ation of
""',, po~ tic pro gram min g whi ch is a
uire ..,.0 fitle~_.rl\S for ea the use of complex procedUie.
,eset f 5.,- f et\>'"· uire s
q quad ~th the Mar kow itz model, it
o ,es o r uos re';l . ulti es asso · te w1
c~a al sis. Mu ch simplif . . . . has found little use
"r 0
~riiit' t .,ortf f •"'e diffiC f por tfol
v ·& r
ication is needed before the
io .an . y Sim plif icat ion is nee ded
elfiCl aose o plic u• ·ons o
atl ctic al ap plic atio ns. .. in the amount and
~e' l aP d
,acuca e \lse foruire pra rfor rn por tfolio analysis; sim plificati. on is
. \so
a nee ded.m
d to pe elec t opt ima l port foli os..
ii' f' cat' b data req dur .
e use d to s h . dex mod els. The
ijteO!'f f itlP\lt. nal proc_e chie
ved re are essentially two types
e O
tat1° thro ug ulinti
__ ;,...dex mod el. The single index model is
~ ,oft\1'~ lifica~.0 n e1sind a d l
ex rno e and rn ,.., the
ijl <f'he sifl\Pd ls: sitlg l
. lific atio n and may be rega rded as b ·
o e . dely use d sirn P M k wit z mod el at the emg at ~ne
f il'de1' ft\ d the rno st w1
p•
other extreme point.
tinu urn , w1. th the . daregio o
n of this con tinu um of pom _w: \i anal .
oifl\Piest at\ il't of a con be pla o o ysis
s ft\e po
ced at the rn1 r
dels ll'\aY
eJlt!e. . de" rno
uiu-W
M -ques-
teeh1'1
o L-- --- --- --- --- -;:; cr•
P_ _ _ _ _ _ _ _ .... 0 nE L
x JN DE 1' l'U- . . dex mo del is that
st?ilGLE l ing the sing le m all stocks are affected by
Fig. 14.3 Opt ima l portfolio. . of sha re pric es reveals that whe n the
b sic noti on und ~ ~ar ket . Cas
'fhe a ents in the stoc asu red by ual ob: rva ~;; y use d stoc k mar ket indices), prices of
Ma rko wit z use d the tech niq ue any of e w1 dow the prices of most shares tend
port foli os. Usi ng the exp ecte d retu
of qua dra tic pro gra mm ing to
identify the ..
rno"et1\ oves up (as rne Wh en the mar ket goe s . n,turn
rn and risk of eac h sec urit y und rna rke ~es tend to inc \ea ::~t one s mig ht be correlated and
cov aria nce esti mat es for eac h pai er considerationelfici'11\ rea son wh y secu rity ta com mon
r of secu ritie s, he calc ulat ed risk rno~~~line- 'fhi s sug g:s:etw een sec response to market
port foli os. The n, for any spe cifi and retu rn for all :~ urit ies, is bec ~~e :de x may be
leas t risk por tfol io usin g qua dra
retu rn, a sim ilar pro ced ure aga in
c val ue of exp ecte d por tfol io
tic pro gra mm ing . Wit h ano ther
retu rn, he detemuned 1
valu e of expected portlo\m
! to
there 1
·s co-movernen
changes. Thi:. ove rne nt of stoc ks wit h. a mar
co-rn ress ion ana lysi s, tak ing th
the
e
retu rnS on an ·
i
stud
ndiv
ied with the help
idua l security as the
d
giv es the min imu m risk por tfol f sunple hne ar reg d the retu rns on e mar ket inde x (Rm) as the mdepen ent
wit h diff eren t valu es of exp ecte io. The process is repeated
d retu rn, the resu ltin g min imu ~e;endent vari able (Ri) an
the set of effi cien t por tfol ios. m risk portfolios constitu\e 1 d end on the retu rn on the market
variab e. f an ind ivid ual sec urit · · ssu med to ep
y a
The retu rn o . d " . dua l sec urit y may b e exp ress ed as:
1~
index. The retu rn of an m 1v1
LIMITATIONS OF MARKOW Ri = CXj + 1-'1 Rm + e-t
R
ITZ MO DE L
One of the mai n pro blem s wit h where · . t f the market's performance .
req uire d for calc ulat ions . An inv
the Ma rko wit z mo del is the larg
e num ber of input data <Xi = Com pon ent of sec uri·ty i's retu rn tha t is ind epe nde n °
. _
Rm = Rate of retu rn on the ma rke t ind ex.
esto r mu st obt ain esti mat es of .
retu rns for all secu ritie s as also retu rn and variance ol h e in K tnve n a change m Rm-
cov aria nce s of retu rns for eac h A. = Con stan t tha t me h pec ted C ang
in the por tfol io. If ther e are N pai r of securities included asu res t e ex 1 o·
sec urit ies in the por tfol io, he ,.,, res1·dua l retu rn-
esti mat es, N vari anc e esti mat es wou ld nee d N return ei = Erro r term rep res ent ·ing th ran dom or th
and N(N -1) /2 cov aria nce esti e . com pon ents , one part du e tob. ne
of 2N + [N(N -1) /2) esti mat es. For mat es, resulting in a to~ This equ atio n bre aks the retu rn stoc k mto two
200 retu rn esti mat exa mpl e, ana lysi ng a set of 200
secu ritie s woul~ reqwre market and the oth er par t ind epe nd
on a th arke t. Toe beta paramete~ m the equa o ,
d It indicates
es, 200 var ianc e esti mat es and 19,9 ent of . \mthe retu m on the mar
a tota l of 20,300 esti mat es. For 00 cov aria nce esti mat es, addingup ~i, mea sure s how sen ket m ; \ return· For
to
1,25 ,7~- It a set of 500 sec urit ies, the esti
mat es requ ired would be
siti ve a sto ck's retu rn 1_s
how exte nsiv ely the retu rn of a
°
wi·t h cha nge s m the mar ede to increase
may be not ed that the num ber
of esti mat es req uire d bec ome s sec un·ty w111 var y of the secu . - 15 · xpect
cov aria nce s betw een eac h pair of large because example, if the f3i of a sec urit y is rity ~ if the market
secu ritie s hav e to be esti mat ed. 2,- the ~ the r : : :
by 20 per cen t wh en the ma rke t
retu rn mcr ea 10 per cent. 1n this case,
Y
~ ·
186 Securit y Analys is and Portfol io Manag ement Portfoli o Selectio n 187
.I . k 15
ii • referr ed to as system atic risk as it aHects all
return decrea ses by 10 per cent, the securi ty return onent of ~15 h uniqu e risk or unsyst ematic risk which
_is expect ed can be
I For a securi ty with /3,- of 0.5, when the marke t return coJ'l\P nt is t e
increa ses to decrease b late d . 0 rnpone _ alled diversi. . bl e ns
. k
I ·
the securi ty return is expect ed to increa se or decrea se by 5 p Wd~ teases bY2o Pe ~1'et re ifiC risk cu·on- It 1s also c_ty are oftenfia .
obtain ed f:rom regress ion analysis
I <>ec
beta coeffic ient greate r than one would sugge st greate
r responer. cent (that isY lo Pett c~l 111e 5 r- di"ers1•fica dO-et
,o,e 11'3' 2 of ecun
a 5 . as well as return s o f a mar'-...et m · d
stock in relatio n to the mar~e t ~nd vice . s1vene 5 ex. For any
versa. lo
ss on the l\ o.sj''l
c.,, 11 tie ~ 0 tlg\l5 of ct;, /3; al\ of the secun 7 turn and risk of the securit y can be calculated.
The alpha param eter a,- md1ca tes what the return se'\J ,ed tirtlate f retll:rn ; the expec te re andaz
of the se . Piltt of A of a securi ty are 2 per cent, 1 .5 and
marke t return is zero. For examp le, a securi. ty with . ~\J,o,e ~s al dat~ ~ahle of "'c1 -value s of Ct;,_ /3; xpect
an alpha ofcurity WouJd b "'
·~ !d to provid e a return of 20 per cent,
er . 3
P cent return even when the mark et return 1s zero and it would+ per cent woe \vheii , j\istofl',q,ecte .... e estillla teJ'l\ark et index is e d risk
of ore if u• ·f the of the securi ty can be calcula ted as
cent at all levels of marke t return . Conve rsely, a
securi ty with earn an additi1.il(i ·~ 1
eiltii gi"el' atttFl~, el)' afl.d l the expec te d return an
would lose 4.5 per cent when the marke t return 1s .
zero and wo anIdalpha of -4 ona1 311.l fore" ecU" O f 120, -
at all levels of marke t return . The positi· · ' 5 .r.11 resP •clflce
. ve alpha thus repres ents au earn 4 -5 Per· Pet c.... nt 'jV" var1 -
R· ==
Ct · + /J;Rm
' -
would be a highly desira ble aspect of a securi.ty, where as a negati sort of b 0 cent ·•q ..,iti' ...eiovv: 1

penalt y to the invest or and 1s . . nus re1,,_ les; 'wflv :::2+ 1 5· 1'2 0) == 32 per cent
an undes irable aspec t of a securi ty. Ve alpha repre""'11 <ltd ~
2
·
The final · th e equati·on, e,-, 1s
term m · t h e unexp ected return
resulti n 8ents i a'f == i2-2 + a •
/3 vm ..
not identi fied by the model . It is referr ed to as the == (1.5)2 (120) + 300
random or residual g from influ
on any value, but over a large numb er of observ .
ations it will averag ereturn · It lllayences t~
Willia m Sharp e, who tried to simpl ify the data inputs == 570
and data tabul o~t to Zero. 1
the Marko witz model of portfo lio analys is, sugge
sted that a satisfa cta on_reqUiredf n: k
would be ~~ev e~ b! aband oning the ~ovar i~nce ory sirn I' 01 and ~s unde r Singl e Index Mode l .
of each securi ty with each oth~ ification rtfoli o ~etur ll .
and substi tuting ~ its f'.lace the relatio nship . t the expec ted portfo lio return and nsk for \
of each sec~ri ty with a market r.sec\lri~ ?t{easuring po. d select ion requ ir~:: c:r~: th a given set of securi
measu red by the single mdex mode l sugge sted ties. The return and
above . This is known as Sha ~d_ex as . . atla1ys1s an hat can be cons
mode l. in le index model .
rp _1nde1 portfoli~ble portfo lios ~ calcu lated using th: st
In the place of [N(N - 1)/2] covar iances requir ed ten as portfo lio alpha plus portfo lio beta
for "the Marko witz model S all po~s1 ortfoli os can e of a portfo lio may . e a
mode l would requir es only N measu res of beta
coeffi cients . ' harpe ris\c. !_ p expect ed return turn- Thus,
p,e d xnarke t re -
Meas uring Secur ity Retur n and Risk unde r titnes exPeete -
RP == a .P + /3 p''-m
~
Singl e Index Mode l
Using the single index mode l, expec ted return of
an indivi dual securi ty may be expreSSed . wei hted avera ge of the specilic return s (alpha s) 0£ the
as: The portfo lio alpha is the g
ft,. = a ,. + /3,- R,,, individual securi ties. Thus, n
The return of the securi ty is a comb inatio n of
two comp onent s: (a) a specific return
a
p
=L ro;a;
i=l
comp onent repres ented by the alpha of the secur
ity; and (b) a marke t related return
compo nent repres ented by the term /3; Rm. The residu where t·
al return disapp ears from the expression of inves tmen t in an indiv i~ual
securi ty.
becau se its averag e value is zero, i.e. it has an = Propo r ion
O)j
- Specif ic retur n of an mdiv1 ua1 securi ty•
e xpect ed value of zero. . • ·d
·
Corre spond ingly, the risk of a securi ty a/
becom es the sum of a marke t related component a; -
. of the Beta coe
ffio·ents of the mdiv1 dual
and a comp onent that is specif ic to the secur ity.
Thus, The por tf o110 beta is the weig hted avera ge .
Total risk = Mark et relate d-r.!sk + Specif ic risk securities. Thus,
~ ,
/32cr2 + er·-.£'\
, m e, \
where ~-_/
af = Varian ce of indivi dual securi ty. where . indiv idual securi ty·
ro; = Propo rtion of inves tmen t m
a~ = Varian ce of marke t index return s. an .
/3i · d" · d al secur ity·
= Beta coeffi cient of an m
a;; = Variance of residual returns of individual- security. lVl u
. . the sum of the
. hted averag e of the s_,,,.;fie
we1g
~·
The expec ted retur n of the portf olio is . . d al secunn es.
/3; = Beta coeffic ient of indivi dual securi ty. t d return s of ind1V1 u
return s and the weigh ted avera ge o f the m arket re1a e
i 188 Security Analysis and Portfolio M anagem

The risk of a portfoli o is measur ed as

portfoli o i~ simply a weight ed avera
ent

the varianc e of the

11 2
·aJ\ce == L W; a,;
2
Portfolio Selection 189

plus a weight ed average of the spec~tc o~ te market related o·rtfoiio reh,- ·dl.lal var1 ;~1
portfol io risk may be express ed a s.. ns s of individ ual securiti
nsks of in·d 1. ns · 1'h )'Ortfo\iO resi 2
( 0) + (Q.1 )2 (240) + (Q.4) (410) + (0 .3)2 (285)
. ....
es in th"idlla\ es tis~Of 2
37
a2 - 132 2 n
"' (O.Z)
e PClttf~~lltj~ I
. ' - '"'" + ,~ w!c,), ho.~ -_ 10 s .45
te d 1J\
. the last row of the
f table.
. dUsing these values , we can ca\culat
wes are J\ 0 for aJ\Y value o pro1ecte market return. For a
Th~ first term constitu tes the varianc e k e
portfol io beta and represe nts th of the market ind
11'"' •: p ,tfoli0 "'"'';; portfol io ,ewm would bee ma, et return
The second term is the weighte de market related risk (or sysetx multiplied b 0
1'f'ecte t we expecte
.. averag e of th emati -
securiti es and represe nts the s ecific r · Y th · tJle e per ce!\· ' R- == exp + /3 p''m
e varianc es of resi c risk) of e sq11 J 15
D
As_ mo<e and mo,e securit ies a,e a:k o, unsyste matic dsk =••I
p,,~'; .• p == 1.575
rrtfoli o become s smalle , and is negli t~d
a,ge po,tfol io, the ,esidua l risk o,
;o "'lun,,, ~•-
the po,tfoli o, the f the po,11ou'
g, e o, .• modern tel siz unsyste m,.,;'·. '<
""11,;i• == 17.475
+ (1.06)(1 5)

nsk become s equal to /320-2 H . h portfol io variaf\C e we need the varianc e of the market
L P m . ence unsyste
the eff matic
ti risk appr{ h ed portfolio risk of >L
ac es ze . Th "'e ,alcl.llatlJ\g t e......J\ varianc e of 320, the portfol io varianc e can
returns
et us conside r a hypoth eti , . ec ve measur e of . be calculat d . ·
. ro and th lls, for for ar1<et re,....,.
basic input data such as weight cal potfoh o of four securiti es e as.
p;~tfoli o risk is / Portfou: jnga~ n 2
securit ies require d for calcul ~ge, a pha~, betas and residua p.ssllfll 2 2
13 p a m + L
a g portfol io return and i e_table belowP~h (J 2
p := i~l ola
. varianc
varianc e. es of the lnd.i
. Ows. the I el

V1dua1
== (1.06)2 (320) + 108.45
--- ~~~ ---J ¼;ii ~;-- --~I~n~p~u~t~D~a~t~a'.____ ____ == 468.002
Security Weightage Alpha Beta Residua T;;----- . . deX roodel provid es a simplif ied method of represe nting the
(W;) (a;) 2 rrance
covariance
(/3;) 'fhe s~g1e 1:ng the securit ies. This simplif ication has resulted in a
A 0.2
( cr,,) substantial reduction
2.0 1.7 relationships a:ed for portfol io analysi s. In the single index model
B 0.1
370-- - .only three estimates are
3 .5 0.5 . inputs
Jil d f requ
reach securit
. y in
. the port f o1·10, namel y spec1. fi c return <lj, measur e of systematic
C 240
0.4 1.5 0.7 neede
. 2
A Od varianc e of the res1·d ual return CJe;.
410 In a dd.1tion
· to these, two estimates of the
D 0.3 0.75 1.3 285 ~0~
ma<kel ;ndex, na,nely the ,na,ke t ,etum -R,, and the va,ianc e ol
Portfolio value
the ma,ket ,eturo a'. ""
1.575 1.06 also needed. Thus, fo,r N securit ies, the numbe r of estimat es require
108.45 d would be 3N+2. For
example, for a portfol io of 100 securit ies, the estima tes require
d would be 302. In contrast
to this, for the Marko witz model , a portfol io with 100 securiti
es would require 5150
estimates of input data (i.e. 2N + lN(N - 1)/21 estimat es).
Using the expecte d portfol io return s and portfol io varianc es
n calcula ted with the single
a,,= L w;a; index model, the set of efficie nt portfol ios is genera ted by means
of the same quadratic
i=l
programming routine as used in the Marko witz model.
= (0.2) (2) + (0.1) (3.5) + (0.4) (1.5) + (0.3) (0.75)

= 1.575
n
MULT I-IND EX MOD EL
/3p = L W;/3;
i=1
The single index model is in fact an oversim plifica tion. lt assume
s that stocks move together
only because of a comm on co-mo vemen t with the market . Many
research ers have found
: ~\2~ (1.7) + (0.1) (0.5) + (0.4) (0.7) + (0.3) (1.3) . ther e are m
that · fl uences other than the marke t that cause stocks to move together.
mhdex models attemp t to identif y and incorp orate these non-ma
Mulh-
·
rket or extra-market factors
t at cause s ecuntie
· · s to move togeth er also into the model. These extra-m arket ac ors are
f t
 190 Security Analysis and Portfolio Management

a set of economic factors th~t acc o~t for com mo

n movemen~ in stock Prices b
ouri ted for by the
aCc market index itself. Fun dam ent al economic vari
. ables eyond ti--
real economic growth, inte rest rates, exchang~ rate s etc. wo uld have a Sign such as . '1qt
in determining security retu rns and hence, the ir ific lI\~ation,
co-movement. ant llnpa~
A multi-index model aug men ts the sing le
ind ex mo del by incorporatm
market factors as additional ind epe nde nt variabl
es. For example, a multi-~~:ese extra
incorporating the market effect and thre e ext ra-m
ark et effects takes the folio . x model
Ri = lXj + /JmRm + f31R1 + /Ji.R2 + /JJR3 + ei Wmg fo
l'!ll:
The model says tha t the retu rn of an ind ivid ual
sec urit y is a function of four f
the general market factor Rm and three extra-mark f . actors-..
attached to the four factors hav e the sam e mea
et actors R1, R2 and R3. The beta coeffi.
nin g as in the single index model.~~
measure the sensitivity of the stock retu rn to thes
e factors. The alp ha parameter a; and;
residual term e; also have the same mea nin g as
in the sing le ind ex model.
Calculation of retu rn and risk of ind ivid ual sec
urities as wel l as portfolio return and
variance follows the same pat tern as in the sing
le ind ex mo del. These values can then be
used as inputs for portfolio analysis and selectio
n.
A multi-index model is an alternative to the sing
le ind ex model. However, it is more
complex and requires more dat a estimates for its
app lica tion . Both the single index model
and the multi-index model hav e help ed to mak e
por tfol io ana lysi s more practical.

SO.LVED EXAMPLES
Example 1 An investor own s a portfolio who
se ma rke t mo del is estimated as:
RP= 2.3 + 0.85 Rm + ep
If the expected return on the mar ket ind ex is 17.5
on the investor's portfolio? per cent, wh at is the expected return
,
Solution Assuming that ep = 0

RP= 2.3 + 0.85 (17.5)

= 2.3 + 14.875
E = 17.175 per cen t
xample 2 An investor ow .
characteristics: ns a portfolio com pos ed of five securities wit. h h folloWin
t e
Security
LJ~!!!
Beta _
------ Random error term Proportion
1
2 1.35
standard deviation (per cent)
3 1.05 5 - 0.10
4 o.so 9 0.20
5 1.50
4 n 1,