MMPF-004 Block-3

MMPF-004 Valuation of Securities
Indira Gandhi
Security Analysis and
National Open University Portfolio Management
School of Management Studies
Block
3
PORTFOLIO MANAGEMENT
UNIT 10 179
Portfolio Analysis
UNIT 11 197
Portfolio Selection
UNIT 12 213
Capital Market Theory
UNIT 13 228
177
Portfolio Management
BLOCK 3 PORTFOLIO MANAGEMENT
Unit 10: Portfolio Analysis explains and illustrates the concepts and measures
of ‘return’ and ‘risk’ as they apply to individual assets as well as portfolio of
assets. This unit also highlights the process of diversification of risk and introduces
the portfolio selection problem and process.
Unit 11: Portfolio Selection explains and illustrates Markowitz’s Approach and
Sharpe’s Single-index Model for selecting optimal portfolio of assets. This unit
also highlights the limitations of these models and discusses some alternative
models like, Multi-Index Model of Goal-Programming approach to portfolio
selection.
Unit12: Capital Market Theory is aimed to introduce general theory of pricing
of the capital assets. It discusses in detail the Capital Assets Pricing Model
(CAPM), pointing out its basic tenets, assumptions, and rationale. This unit also
explains Capital Market Line (CML) and the Security Market Line (SML). It
also discusses beta measure of risk and its implications for portfolio selection.
This unit highlights the limitations of CAPM and introduces the alternative
approach to pricing the capital assets, namely, Arbitrage Pricing Theory (APT).
Unit 13: explains out the meaning and need for portfolio
revision. It contrasts ‘active’ and ‘passive’ portfolio revision strategies. It also
highlights constraints in portfolio revision and explains and illustrates formula
plans for Portfolio revision, namely-constant Dollar-Value Plan, Constant-Ratio
Plan and Variable-Ratio Plan.
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Portfolio Analysis
UNIT 10 PORTFOLIO ANALYSIS
Objectives
After reading this unit you should be able to:
• explain and illustrate the concepts and measures of return and risk as
they apply to individual assets as well as portfolio of assets;
• highlight the concept of diversification of risk;
• discuss the portfolio selection problem and the process.
Structure
10.1 Introduction
10.2 Need for Portfolios
10.3 Risk and Return
10.4 Expected Risk and Return from a portfolio
10.5 Portfolio Analysis
10.6 Portfolio Selection
10.7 Summary
10.8 Key words
10.9 Self Assessment Questions
10.10 Further Readings
10.1 INTRODUCTION
Portfolio analysis is a process of evaluating a group of financial assets or
investments, known as a portfolio, to determine their risk and return
characteristics. The goal of portfolio analysis is to construct an efficient
portfolio that balances the risks and rewards of different investments. Portfolio
analysis involves several steps, including identifying the assets in the portfolio,
analyzing their performance and risks, determining their correlation with one
another, and constructing a portfolio that maximizes returns while minimizing
risks. This process can be conducted using a variety of methods and tools,
such as statistical models, optimization algorithms, and risk management
strategies.
One of the key concepts in portfolio analysis is diversification, which involves
spreading investments across different asset classes and securities to reduce
overall risk. By diversifying a portfolio, investors can potentially lower the
impact of any one asset’s poor performance on the overall portfolio’s returns.
Portfolio analysis is essential for any individual or institution that invests in
financial assets, such as stocks, bonds, mutual funds, and exchange-traded
funds (ETFs). By analyzing their portfolio, investors can make informed
decisions about their investment strategy, such as which assets to buy, hold, 179
Portfolio Management or sell, and how much to allocate to each asset. In this unit we will study the
concepts of portfolio analysis.
10.2 NEED FOR PORTFOLIOS

Portfolios serve several important purposes for Investors Here are some of
the key reasons why portfolios are necessary:
1. Diversification: Portfolios allow investors to diversify their investments,
spreading their money across different asset classes, sectors, and
geographic regions. This reduces the overall risk of the portfolio and helps
to ensure that no single investment has too much influence on the overall
performance.
2. Risk management: By analyzing the risks associated with each
investment in a portfolio, investors can manage their risk exposure more
effectively. They can identify investments with high levels of volatility
and make adjustments to the portfolio to reduce overall risk.
3. Return maximization: Portfolios can be constructed to maximize returns
based on an investor’s risk tolerance and investment goals. By combining
different assets with varying risk and return characteristics, investors can
aim for a portfolio that generates the highest possible returns for a given
level of risk.
4. Monitoring and tracking: By regularly reviewing the performance of a
portfolio, investors can ensure that their investments are meeting their
expectations and adjust their strategy as needed. This can help investors
stay on track to meet their financial goals over the long term.
5. Flexibility: Portfolios offer investors a flexible way to manage their
investments. They can adjust the composition of their portfolio as their
financial circumstances or investment goals change, and they can also
use different types of investments to achieve specific objectives.
The portfolios are essential for investors who want to manage their investments
effectively, minimize risk, and achieve their financial goals over the long
term.
10.3 RISK AND RETURN

Any investment decision requires an estimate of return and risk associated
with the investment. However, the most difficult task of investment decision
is estimation of return and risk. If we are able to estimate a range of expected
return, then it is possible to estimate the probabilities associated with the
range of expected return to get the risk measure. In practice, however, the
return and risk of the securities are estimated based on the historical return
and risk of securities. A stock’s single period basic return is:
Total Return t = Dividend + (Market Price t- Market Price t-1)
____________________________________
Market Price t-1
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There are different measures of historical return. The most elementary form Portfolio Analysis
of return measure is holding period yield or return. Here, the dividend received
during the holding period is added along with the capital gain and divided by
the purchase price. If the holding period is more or less than one year, normally
the holding period return is stated for one-year period. This measure is not
much useful if one wants to measure the risk associated with the security.
There are two other measures of return by which one can measure risk.
a) Arithmetic Average: The arithmetic average return is equal to sum of
returns of period divided by ‘n’. For instance, if the stock has offered a
holding period return of 11% in period 1, 12% in period 2 and 16% in
period 3, then the arithmetic average return is equal to 13%. Though it is
better than holding period return, this measure suffers because of its failure
in considering time value of money. Another problem of this measure is
differential treatment of positive and negative return. For instance if a
stock price increases from ` 10 to ` 20 in period 1 and declines back to
` 10 in period 2, the Arithmetic average return is still positive value of
25% (Period I return is 100% and Period 2 return is -50%; Total return is
50% and hence average return is 25%).
b) Geometric Average: The geometric average return is based on the
compound value and is also called time-weighted average return. It
addresses the problem of differential treatment of positive and negative
return described above. The geometric average return is computed as
follows:
GMR = [(1 + R1 ) x (1 + R 2) x (1 + R 3).....x (1 + R n)]1/n -1
Illustration: Five years back, you have applied and was allotted 100 shares
of a company at the rate of ` 50 per share (Face Value `10). The price at the
end of each year along with annual dividend per share received from the stock
is as follows:
Year
Dividend per share (`) 1.5 1.5
Market Price (` ) 40 55 70 77 91
Find the Holding Period Return (HPR), Arithmetic Average and Geometric
Average return of the stock.
HPR : [Dividend (` 8) + Capital Appreciation (` 41)] /
Investment (` 50) ]
: 49/50 = 98% for five years or 19.60% per year
AA Return : [R1 (-18%) + R2 (41.25%) + R3 (30%) + R4 (12.86%) +
R5(20.78%)]/5 :17.38%
Note: R1 is equal to [(41-50)/50], R2 is equal to [(56.5 - 40)/40], etc.
GA Return : [(1+ R1) x (1+ R2) x (1+ R3)x(1+R4) x (1+R5)]1/5 – 1
: [(.82) x (1.41) x (1.30) x l.13)x(1.21%)]1/5-1
: 15.47% 181
Portfolio Management As you may observe, for the same set of data, we get different values of return.
HPR is the highest and GAR is the lowest. The Geometric Return is lower
than other two returns because of compounding.
In addition to the above two types of return, a foreign investor or foreign
fund would compute dollar-weighted return to adjust differences in the foreign
exchanges between the point of investment and sale. For example, if a foreign
fund purchased a stock at ` 80 today when the US Dollar - Rupee rate is ` 80
per US Dollar and sold the stock at ` 85 at the end of one year, the holding
period return in Rupee term is 7.5 % [(85-80)/80]. However, if the Rupee
depreciates during this period and quotes ` 86 per US Dollar, the foreign fund
incurs a loss because it can get less than one Dollar with the sale value of the
stock. The loss is equal to 1.16% [$1- $(55/56)].
While historical return gives a fair idea about the future return, they are often
used to measure the risk. It is true that it is more relevant to use expected risk
by measuring the probability associated with various returns, often such
measure is, not used in practice. Historical data is generally used to measure
the risk. The risk associated with an investment in. stocks is measured using
variance or standard deviation of the historical return. A question with variance
as a measure of risk is: why count ‘happy’ surprises (those above the average
historical return or expected return) at all in a measure of risk? Why not just
consider the deviations below the average historical return or expected return
(i.e. the downside danger)? Measures to do so have much to recommend them.
But if a distribution is symmetric, such as the normal distribution, the result
will be the same. Because, left side of a symmetric distribution is a mirror
image of the right side. Although distributions of historical or forecasted
returns are often not normal, analysts generally assume normality to simplify
their analysis.
Activity 1
Scan the NSE-50 websites and select stocks of 10 companies. From the
data available try to find:
a) Holding period return
b) Arithmetic mean return
c) Geometric mean return
Tabulate the results and compare the risk and return status of the
companies.
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Statistical measures of risk

Let us now discuss the statistical measures of risk.There are two types of
182 statistical measures. They are:
a) Standard Deviation (SD) Portfolio Analysis
b) Coefficient of Variation (CV)

1. Standard Deviation (SD) of Returns
We know that risk is the dispersion of returns for an expected value. SD
is one of the most common methods to measure risk of an asset statistically.
The formula is:
x Pri
Where
is standard deviation
ki is return for the ith possible outcome
k is most likely expected return
Pri is probability associated with its return
N is number of outcomes considered
It can be said that greater the SD, the greater is the risk of an asset or
investment. Suppose Asset A has lower SD than Asset B then, Asset B is
riskier than Asset A as it has higher SD. Therefore, we can say that SD is an
absolute measure of dispersions which does not consider the variability of
return with respect to the expected value.
2. Coefficient of Variation (CV)
It is said to be a measure of relative dispersion (risk) or risk per unit of
expected return. It basically coverts SD of the expected values to relative
values. The equation for computing CV is as follows:
CV = σk / k
In this case also higher the value of CV, the riskier is the asset.
Let us now understand the concept through graphical representation. Figure
10.1 that depicts the distribution of returns that might be expected for two
investments, A and B.
Probability
B
Expected Rate of Return

Figure 10.1 : Possible Outcomes of two Independent Investments 183
Portfolio Management The mean or expected return, at the vertical dotted line, is the same for both
investments. But, investment B is riskier. With investment A, the distribution
of returns (or possible outcomes) is more closely grouped about the mean
value. In other words, the variance is smaller than that of investment B.
Consequently, it can be said with greater degree of accuracy that our forecast
will be close to the actual return from investment A.
When we move from evaluating a single asset in isolation to evaluating a
portfolio, our return-risk analysis changes. Return is still the expected return,
but for a portfolio the return will be the average return from all the assets held
in the portfolio. Risk is still the variance (or standard deviation) of the expected
returns from the portfolio. The investor is still concerned with upside potential
and downside danger. However, the risk of a combination of assets is very
different from a simple average of the risk of individual assets. Most
dramatically, the variance of a portfolio of two assets may be less than the
variance of either of the assets themselves. We will examine all these aspects
in the discussion that follows.
10.4 EXPECTED RISK AND RETURN FROM A

PORTFOLIO
The return on a portfolio of assets is simply a weighted average of the return
on the individual assets. The weight applied to each return is the fraction of
the portfolio invested in that asset. Thus, Where
R(p) = the expected return of the portfolio;
Xi = the proportion of the portfolio’s initial fund invested in asset
‘i’
Ri = the expected return of asset ‘i’; and
n = the number of assets in the portfolio.
To illustrate the application of the above formula, let us consider a portfolio
of two equity shares A and B. The expected return on A is, say, 15 per cent
and that on B is 20 per cent. Further assume that we have invested 40 per cent
of our fund in share A and the remaining in B. Then, the expected portfolio
return will be
0.40 x 15 + 0.60 x 20 = 18 per cent.
It may be noted here that portfolio weight can be either positive or negative.
In case of securities, the weight will be negative when investor enters into
‘short sales’. Usually, the investors buy securities first and sell them later.
But with a ‘short sale’ this process is reversed; the investors sell first the
securities that they do not possess, and buy them later to cover the sales.
Having discussed the computation of expected portfolio return, we now turn
to the measurement of variance of portfolio’s return (i.e., the risk of the
portfolio). As mentioned earlier, assets when combined may have a greater or
lesser risk than the sum of their component risks. This fact arises from the
degree to which the returns of individual assets move together or interact. It
184
is vital, therefore, to consider covariance of returns in estimating portfolio Portfolio Analysis
variance.
Let us intuitively understand why the risk of portfolio of stocks is lower than
the sum of the risk of the individual stocks. Suppose you have invested your
wealth in two securities. Assume the securities prices move in opposite
direction such that when one security gains, the other security incurs loss.
For instance, if one security reports a gain of 10% in a period, the other one
reports a loss of 5%. In the next period, the security, which lost 5% shows a
gain of 12% but the other one lost 7%. Though the two securities individually
has a variance, an investment of equal amount in these two securities will
have a constant return of 5% during the period. In other words, the variance
of the portfolio return is zero.
We may not find assets that move in opposite direction in the real life because
the same set of factors affect the performance of several assets. At the same
time, assets are also not perfectly affected by the factors and hence there is a
scope for reduction in the variance of portfolio of assets. We will explain the
same with the help of portfolio of investments in three hypothetical stocks.
Three equity shares as shown in table 10.1 with the return-risk characteristics
are considered for this purpose:
Table 10.1: Risk-Return characteristics
Assets Monthly Average Standard Proportion

Return (%) Deviation (%) Invested (%)
A 8.89 19.55 33
B 5.12 7.99 33
C 3.42 6.18 34
Monthly returns here represent average appreciation of share prices estimated
on the basis of price movements over 26 monthly intervals during the period
2022 to February 2023. A weighted average of standard deviation of each
share returns works out to (.33 x 19.55 + .33 x 7.99 + .34 x 6.18) i.e.11.18 per
cent. However, a direct estimation of standard deviation of historical portfolio
returns yields a figure of 9.61 per cent. Thus, the portfolio risk, as measured
by standard deviation, is less than the sum of component risks. The lower
portfolio risk in this case is due to the fact that the returns of the select scrips
have not exhibited greater tendency to move together. In fact, the correlation
co-efficient of returns between A and C and that between A and B were found
to be low (.3 and 4 respectively) during the period under consideration.
The computation of the portfolio variance in the above example is based on
the following formula:
σ2 (p) = xi x j σ ij
Eq. (1)
where ‘σ ij ’ denotes the covariance of returns between asset i and asset j. An
explanation of the formula is now in order.
We start off with the most important element of this formula, namely,
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Portfolio Management covariance. It is a statistical measure of how two random variables, such as
the returns on asset and ‘move together’. A positive value for covariance
indicates that the assets returns tend to go together. For example, a better-
than-expected return for one is likely to occur along with a better-than-
expected return for the other. A negative covariance indicates a tendency for
the returns to offset one anther. For example, a better-than-expected return
for one asset is likely to occur along with a worse-than - expected return for
the other. A relatively small or zero value for the covariance indicates that
there is little or no relationship between the returns for two assets.
Closely related to covariance is the statistical measure known as correlation.
The relationship is given by
σij = Uij σi σ j
Where ij denotes the correlation coefficient between the return on asset ‘i’
and that on ‘j’. The correlation coefficient simply rescales the covariance to
facilitate comparison with corresponding values for other pairs of random
variables. The coefficient ranges from - 1 (perfect negative correlation) to +
1 (perfect positive correlation). A co-efficient of 0 indicates that returns are
totally unrelated.
Given an understanding of covariance and correlation, next logical step is to
know how the double summation of equation (1) is performed. The easiest.
way to understand equation (1) is form a n x n table. Suppose there are three
stocks in the portfolio, then the equation 10.2 is equal to
Table 10.2: Variance-Covariance Matrix
The above table has to be expanded if the number of securities are more than
three. For example, if the number of stocks are 5, then we have to frame 5 x 5
table. The variance of the portfolio is equal to sum of the values in the above
cells. In the above table, Wx, Wy and Wz are proportions of investments
made in security X, Y and Z. The variance of the security X, Y and Z appears
in the diagonal cells as σ xx, σ yy, and σ zz . The covariance between the securities
appears in non-diagonal cells as σ xx,, σ yy, and σ zz. You may also note, the
covariance of σ xy is equal to covariance of σ yx. Thus, if the number of assets
in the portfolio is three, then the portfolio variance can be expressed as follows:
σ2 (p)= Wx2 σ xx + Wx2 σ xx + Wy2 σ yy + Wz2 σ zz + 2Wx Wy σ xy + 2Wx Wz σ xz + 2Wy Wz σ yz
186
Table 10.3:Weekly Return, Variance and Standard Deviation of H, I and T Portfolio Analysis
H I T
Mean 0.38% 0.64% -0.25%
Variance 0.0029 0.0133 0.0048
Standard Deviation 5.37% 11.55% 6.93%

Table 10.4:Variance and Co-variance Matrix of H, I and T
Covariance between H I T
H 0.0029 0.0001 0.0011
I 0.0001 0.0133 0.0016
T 0.0011 0.0016 0.0048

Note: The values of diagonal elements are variance.
Table 10.5 :The variance of the portfolio
Stocks Proportion H I T
of 50% 30% 20%
H 50% . 5 x . 5 x.0029
I 30% .5 x .3 x .0001 .3 x .3 x .0133 .2 x .3 x .0016
T 20% .5 x .2 x .0011 .3 x .2 x.0016 .2 x .2 x .0048
The sum of the cells is equal to 0.002538, which is equal to the variance or
risk of the portfolio. The risk of the portfolio can also be expressed in terms
of standard deviation. In such case, the portfolio risk is equal to:
σ2 (p)= .002538
σ (p)= = .002538 = 0.50375 or 5.03%
The return of the portfolio is 0.33% per week. It may be noted that the risk of
the portfolio that we computed is much lower than the weighted average
variance or risk of the individual securities in the portfolio. The reduction
portfolio risk is mainly on account of diversification and less than perfect
correlation between the three stocks.
DIVERSIFICATION OF RISK
Efforts to spread and minimize portfolio risk take the form of diversification.
Most investors prefer to hold several assets rather than putting all their eggs
into one basket, with the hope that if one goes bad, the others will provide
some protection from extreme loss. Surely enough, there is merit in this
approach; although some investors hold a contrary view point that recommends
putting all eggs into one basket and then keeping a sharp eye on the basket.
It is not difficult to understand that adding more assets in the portfolio can
reduce the overall portfolio risk. Consider the table drawn earlier to compute 187
Portfolio Management the portfolio risk and look into the diagonal cells. The diagonal cells contain the
variance of securities in the portfolio. In that example, we assumed that an equal
investment is made in three stocks. The sum of the diagonal cells is equal to sum
of the variance of three securities multiplied by (1/3)2. Suppose, we add one more
stock in the portfolio and revise our weights to 0.25 for each stock. The values of
diagonal cells is now equal to sum of the variance of four securities multiplied by
(1/4)2. We know (1/4)2 < (1 /3)2. Suppose, if the number of securities in the portfolio
is increased to 20, then the value of the diagonal cells is equal to sum of the
variance of individual securities multiplied by (1/20)2. The value of (1/20)2 is
equal to .0025 and close to zero. Since the multiplier is now close to zero, the
sum of the diagonal cells will reach close to zero. Thus, when a security is added
to the portfolio, the value of diagonal cells is close to zero and thus reduced the
variance of the portfolio. However, there is a limitation in adding securities to
reduce the risk because the diagonal cells value cannot be reduced below zero
(i.e. negative) to reduce the portfolio risk further. Thus, beyond a level,
diversification fails to yield further benefit by way of reducing the risk. This is
being illustrated in figure 10.2.
Risk
Number of Securities
Figure 10.2 : Diversification of Risk
It may be noted that beyond certain portfolio size, the reduction in risk is
marginal and insignificant.
Activity 2
a) Define the following terms.
i) Portfolio Risk.
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ii) Variance-Covariance Matrix.
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Portfolio Analysis
10.5 PORTFOLIO ANALYSIS
We have discussed that risk is reduced when the portfolio includes one stock
in the portfolio. The above observation is not universal in a sense that if the
new stock is perfectly correlated with other securities in the portfolio: In
other words, the job of investment analysts or any other persons responsible
in constructing the portfolio is to identify stocks or securities that are less
related with each other for portfolio construction. The risk of the portfolio
can be reduced to zero if the correlation between the assets included in the
portfolio is equal to minus 1. However, such securities are difficult to identify
in the market. If two securities are perfectly correlated, then there is no
diversification benefit and such combination will not reduce the risk of the
portfolio. There are only very few securities in the market whose correlation
is equal to minus one. What is more prevalent in the market is securities
whose return are correlated between minus 1 to plus 1. Depending on the
level of correlation, diversification reduces the risk of the portfolios. The
relationship between the assets and its impact on portfolio risk is explained
below in Figure 10.3 with the help of two securities.
Figure 10.3: Correlation and Portfolio Risk

(b) Correlation = +1 (c) Correlation = 0.72
Figure 10.3 (c) is more relevant for our discussion since the correlation
between the securities is often less than 1 and greater than zero. In such a
situation, when an investor combines such securities, the risk of the security
is initially reduced. Let us see an example in the table 10.6. Assume there are
two companies H and I.
Table 10.6: Portfolio Analysis
S.No. Proportion of Investment in Portfolio Return Portfolio Risk (Variance)
H I
100% 0% 0.38% 0.00289
80% 20% 0.43% 0.00240
60% 40% 0.48% 0.00320
40% 60% 0.54% 0.00529
20% 80% 0.59% 0.00867
0% 100% 0.64% 0.01334
Note: Correlation between H and I is. 0087
189
Portfolio Management The risk and return of the portfolio is plotted below to show how the graph
looks similar to one shown in Figure 10.3 (C)
0.70%
0.60%
0.50%
0.40%
0.30%
0.000 0.005 0.010 0.015
Risk
Figure 10.4: Risk and Return of Portfolios of H and I
If there are 10 securities in the market, it is possible to draw the graphs of the
above for a number of combinations of two-securities.
10.6 PORTFOLIO SELECTION

We have that combination of securities which normally reduces the risk. Often,
it also leads to an increase in return, which is good for investors. That is, you
are able to achieve higher return and also lower risk through diversification.
The problem is if there are large number of securities in the market, how to
determine the optimum portfolio, which reduces the risk while keeping the
return constant or increasing the return. We first provide an intuitive
understanding of the concept. If there are large number of securities in the
market and if you are able to form a two- security portfolio and find the
portfolio return and risk for various combinations as discussed above, then
you will have a large number of graphs as in figure - 10.3 (C).
Steps in Portfolio selection
Portfolio selection is the process of constructing an investment portfolio by
selecting a mix of assets that is expected to achieve a specific investment
objective, given an investor’s risk tolerance and investment horizon. The steps
in portfolio selection are as follows:
1. Define investment objectives: The first step in portfolio selection is to
define the investment objectives. This involves determining the investor’s
goals, risk tolerance, investment horizon, and other investment
preferences.
2. Identify available assets: The next step is to identify the available assets
that can be included in the portfolio. This involves researching various
investment options, such as stocks, bonds, mutual funds, exchange-traded
funds (ETFs), real estate, commodities, and alternative investments.
3. Assess asset classes: The next step is to assess the potential risk and
return of the different asset classes. This involves analyzing historical
performance data, evaluating the economic and market trends, and
considering other relevant factors that may affect the future performance
190 of the assets.
4. Determine asset allocation: Once the investor has identified the available Portfolio Analysis
assets and assessed their potential risk and return, the next step is to
determine the optimal asset allocation. This involves deciding how much
of the portfolio should be invested in each asset class, based on the
investor’s risk tolerance and investment objectives.
5. Select specific investments: After determining the asset allocation, the
next step is to select specific investments within each asset class. This
involves evaluating individual securities or funds, considering factors such
as management quality, performance history, fees and expenses, and other
relevant factors.
6. Monitor and rebalance: Finally, once the portfolio has been constructed,
the investor should regularly monitor the performance of the investments
and make adjustments as necessary to maintain the desired asset allocation.
This may involve rebalancing the portfolio periodically to ensure that it
remains aligned with the investor’s investment objectives and risk
tolerance.
In the figure 10.5 we have shown five combinations. Now the issue is how to
select a portfolio, which is good in terms of minimizing risk and maximizing
return. Now carefully look into the above figure particularly on the dashed
line. There are five portfolios offering same risk but different returns. Consider
the two extreme Portfolios- Portfolio X and Portfolio Y. While X offers lowest
return, Y offers highest return for the same level of risk. Now, we can say all
four portfolios below Y are inefficient in a sense that you would not buy such
portfolio with the same risk level to earn lower return. If we eliminate all
such inefficient portfolios, we will get a smooth curve, which connects the
left extreme values of the curves. Such an efficient set of the portfolios is
shown in figure 10.6.
Return
Risk
Figure 10.5: Risk and Return of Two-Stock Portfolios
The new curve A and B connects all left-extreme values of earlier portfolios
and become efficient set of portfolios. For instance, we don’t have any
portfolios above this curve to show better return for a given level of risk. All
portfolios below this curve of A and B are inefficient and hence no one prefer
such combination of stocks. All points in the curve are efficient because it is
not possible to evaluate two points in the curve and conclude one is better
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Portfolio Management than the other. They are all efficient portfolios because for a higher risk, the
expected return is also high. Depending on the investors risk and return
expectation, they can pick up any combination. If an investor like to have
low risk, then she or he will select a combination of stocks close to point A.
On the other hand, if an investor likes to assumes more risk, she or he will
prefer a portfolio close to point B.
Figure 10.6: Efficient Set of Portfolios
If the above understanding is clear intuitively, we can now proceed to learn

how to find an optimal portfolio.
Markowitz Model
The Markowitz Model of Mean Variance is a portfolio optimization theory
developed by Harry Markowitz in 1952. It is one of the most widely used
models for constructing an efficient portfolio. The model assumes that
investors make investment decisions based on two factors: expected return
and risk. The mean variance model aims to find the portfolio that provides
the highest expected return for a given level of risk or the lowest risk for a
given level of expected return. The model is based on the concept of
diversification, which means spreading the portfolio across multiple
investments to reduce overall risk.
The Markowitz model calculates the expected return and variance of each
asset in the portfolio and then combines them to calculate the expected return
and variance of the overall portfolio. The model uses the covariance between
assets to determine the extent to which different assets in the portfolio move
together. A negative covariance means that the assets move in opposite
directions, reducing the overall risk of the portfolio, while a positive covariance
means that the assets move in the same direction, increasing the overall risk
of the portfolio. The model then uses a mathematical optimization process to
identify the portfolio with the highest expected return for a given level of risk
or the lowest risk for a given level of expected return. This is known as the
efficient frontier, which represents the set of all efficient portfolios for a given
level of risk.
The Markowitz Model of Mean Variance is widely used by investors, financial
analysts, and portfolio managers to construct an efficient portfolio that
192 balances the risk and return of different investments. It is an important tool
for modern portfolio theory and has been used extensively in investment Portfolio Analysis
management, asset allocation, and risk management.
One important concept that Markowitz emphasized for the first time was that
some measure of risk, and not just the expected rate of return, should be
considered when dealing with investment decision. Markowitz’s approach to
portfolio analysis and selection attracted a number of academicians and
practitioners, who subsequently began to adjust the basic framework so that
practical application could be more readily considered.
Activity 3
1) List out four basic steps of portfolio selection process.
...........................................................................................................
...........................................................................................................
...........................................................................................................
...........................................................................................................
2) Whose work marked the beginning of modern portfolio theory?
...........................................................................................................
...........................................................................................................
...........................................................................................................
...........................................................................................................
10.7 SUMMARY
The unit describes the basic components of portfolio selection process.
Beginning with the estimation of a portfolio’s expected return and risk, which
in turn involves estimation of such input data as expected return, variance
and covariance for each of the assets contained in the portfolio, we have
explained why an investor should consider only the ‘efficient set’ out of the
feasible set of portfolios. Once the efficient portfolios are delineated, the
investor will next ‘select the ‘optimal’ portfolio depending upon his or her
‘trade-off’ between return and risk. In terms of graphical analysis such optimal
portfolio will be located at the point where indifference curve that summarises
the investors risk-return trade-off, is tangent to the efficient set. In this kind
of approach to portfolio selection, it is assumed that rational investors are
risk averse and prefer more return or loss. Finally, the portfolio selection
approach presented here epitomizes the Markowitz’s model developed in early
1950s.
10.8 KEY WORDS

Correlation coefficient : is a statistical measure similar to covariance in,
that it measures the degree mutual variation
between two random variables.
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Portfolio Management Covariance : is a statistical measure of the relationship
between two random variables.
Diversification : means the spreading of investments over more
than one asset with a view to reduce the
portfolio’s risk (i.e., the variability of expected
portfolio returns).
Efficient set : is the set of portfolios of a given population of
(Efficient frontier) assets which offer the maximum possible
expected return for a given level of risk.
Expected rate of return : is the return on an asset (or portfolio) over a
holding period that an investor anticipates to
receive.
Optimal portfolio : means the feasible portfolio that offers an
investor the maximum level of satisfaction, given
his or her own preference for return and risk.
Portfolio : refers to collection of assets (financial or physical
or both).
Standard deviation : is a measure of the dispersion of possible
outcomes around the expected outcome of a
random variable.
Variance : is the squared value of the standard deviation.
Variance-covariance : symmetrically arrays the covariance between a
matrix is a table number of random variables.
10.8 SELF-ASSESSMENT QUESTIONS

1) The following forecasts have been made for investments A and B.
Investments A Investments B
Return (%) Probability Return (%) Probability
10 .05 2 .05
15 .20 12 .25
20 .50 20 .40
25 .20 28 .25
30 .05 38 .05
Calculate the expected rate of return and standard deviation. Which investment
has more upside potential and downside danger?
2) If a portfolio’s expected return is always equal to the weighted average of
the expected return of the component assets, why is not portfolio risk
always equal to the weighted average of the component assets’ variances?
Explain.
194
3) Explain the following in your own words and using graphs: Portfolio Analysis
a) diversification of risk
c) selection of optimal portfolio
10.9 FURTHER READINGS

Alexander, Gordon J., Sharpe, William F., and Jeffery V. Baibey. (1990).
Fundamentals of Investments, (3rd ed.) Prentice-Hall, Inc.
Chandra, P. (2018). Investment Analysis & Portfolio Management (5e). Tata
McGraw Hill.
Elton, Edwin J. and Gruber, Matin J.( 1987). Modern Portfolio Theory and
Investment Analysis, John Wiley & Sons.
Fischer, D. E., Jordan, R. J., & Pradhan, A. K. (2018). Security Analysis
Portfolio Management (7th ed.). Pearson Education.
IIT Kharagpur [nptelhrd]. (2012). Mod-01 Lec-21 Introduction to Portfolio
Management [Video]. YouTube. https://www.youtube.com/
watch?v=Fv63XWOlERM
IIT Kharagpur [nptelhrd]. (2012). Mod-01 Lec-22 Introduction to Portfolio
Management (Contd.) [Video]. YouTube. https://www.youtube.com/
watch?v=TSMn8kYyG50
IIT Kharagpur [nptelhrd]. (2012). Mod-01 Lec-27 Markowitz Optimal Portfolio
Selection Model [Video]. YouTube. https://www.youtube.com/
watch?v=ptXRZpyqyaA
Reilly, F. K., Brown, K. C., Gunasingham, B., Lamba, A., & Elston, F. (2019).
Investment Analysis & Portfolio Management. Cengage AU.
Rustagi, R. (2021). Investment Analysis & Portfolio Management. Sultan
Chand & Sons.
Singh, J. P., [IIT Roorkee]. (2021). Lecture 41: Mean Variance Portfolio
Optimization I [Video]. YouTube. https://www.youtube.com/
watch?v=fi8SJSKjP1M
Optimization II [Video]. YouTube. https://www.youtube.com/
watch?v=D89CPdkPgFU
Optimization IV [Video]. YouTube. https://www.youtube.com/
watch?v=9eJDNrfMeU0
Optimization V [Video]. YouTube. https://www.youtube.com/
watch?v=eTaUv5zOKRU
195
Portfolio Management Optimization VI [Video]. YouTube. https://www.youtube.com/
watch?v=1rXzI9Nsl7M
Optimization VII [Video]. YouTube. https://www.youtube.com/
watch?v=7clNBBdawnU
Optimization VIII [Video]. YouTube. https://www.youtube.com/
watch?v=DpyCUK733Xs
Singh, J. P., [IIT Roorkee]. (2021).). Lecture 43: Mean Variance Portfolio
Optimization III [Video]. YouTube. https://www.youtube.com/
watch?v=jxn7PAKGkBI
Tripathi, V. (2023). Taxmann’s Fundamentals of Investments. Taxmann
Publications Private Limited.
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Portfolio Analysis
UNIT 11 PORTFOLIO SELECTION
Objectives
After reading this unit you will be able to:
x Understand the risk associated with the preference of investors;
x Explain the steps involved in generating frontier; and
x Discuss the basic tenets of Sharpe’s single-index model.
Structure
11.1 Introduction
11.2 Risk and investor preference
11.3 Generating efficient frontier
11.4 Efficient set
11.5 Sharpe’s signle index model
11.6 Other portfolio selection models
11.7 Summary
11.8 Key words
11.1 INTRODUCTION
Portfolio selection is the process of constructing an investment portfolio that
maximizes returns while minimizing risk. It involves selecting a combination
of assets that have different levels of expected returns, risk, and correlation
with each other. The goal of portfolio selection is to find the optimal mix of
assets that provides the highest expected return for a given level of risk, or
the lowest risk for a given level of expected return.
The concept of portfolio selection was first introduced by Harry Markowitz
in 1952 in his seminal paper, “Portfolio Selection”. Markowitz showed that
investors can reduce risk by diversifying their investments across multiple
assets, rather than investing in a single asset. He developed the concept of the
efficient frontier, which is a set of optimal portfolios that offer the highest
expected return for a given level of risk, or the lowest risk for a given level of
expected return.
We have learnt that an investor’s opportunity set of investments or portfolios
will be defined by the ‘efficient set’. But we left the question of actually
finding the efficient set unanswered. This unit will first provide a logical
approach to delineating efficient set. We will then discuss some of the practical
problems of implementing this approach, and present another model,
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Portfolio Management known as ‘single-index model’, that simplifies the portfolio selection process
to a great extent. Finally, we will indicate some other portfolio selection
techniques.
11.2 RISK AND INVESTOR PREFERENCE

Risk and investor preference are two important concepts in the world of finance
and investing. Risk refers to the uncertainty or variability of returns associated
with an investment. Investor preference refers to the particular set of
preferences, beliefs, and attitudes that an individual investor has towards risk
and return.
Different investors have different preferences when it comes to risk. Some
investors are risk-averse and prefer investments that have lower levels of
risk, even if it means accepting lower returns. Other investors are more risk-
tolerant and are willing to accept higher levels of risk in order to potentially
earn higher returns.
Investor preference can also be influenced by factors such as age, financial
goals, and investment horizon. For example, a young investor with a long
investment horizon may be more willing to take on higher levels of risk in
order to potentially earn higher returns, while an older investor approaching
retirement may be more concerned with preserving their capital and may
therefore prefer investments with lower levels of risk.
Ultimately, an investor’s preference for risk is a highly personal decision that
should take into account their individual financial situation, investment goals,
and personal beliefs. It is important for investors to have a clear understanding
of their risk tolerance and to carefully consider the potential risks and rewards
associated with any investment before making a decision.
Generation affluent frontiers
The term “generation affluent frontiers” refers to the emerging middle class
and wealthy populations in developing countries, particularly in Asia, Africa,
and Latin America. These individuals are often the first in their families to
achieve a certain level of financial success and have greater access to
education, technology, and global markets than previous generations.The
generation affluent frontiers are an important demographic for companies and
investors, as they represent a growing consumer base with increasing
purchasing power. These individuals are often highly educated and digitally
connected, and they are interested in products and services that reflect their
values and lifestyles.
The rise of the generation affluent frontiers has been driven by a variety of
factors, including economic growth, urbanization, and demographic shifts.
As these populations continue to grow and become more affluent, they are
expected to play an increasingly important role in driving global economic
growth and shaping consumer trends. However, it is important to note that
the generation affluent frontiers also face a number of challenges, including
income inequality, political instability, and environmental degradation.
198
Addressing these challenges will be crucial to ensuring the long-term Portfolio Selection
sustainability of their economic growth and development.
The emergence of the generation affluent frontiers has important implications
for portfolio selection and asset allocation strategies. As these populations
continue to grow and become more affluent, they are likely to play an
increasingly important role in global economic growth and to drive demand
for a wide range of products and services. Investors looking to capitalize on
this trend may consider incorporating investments that have exposure to these
emerging markets into their portfolios. This may include investments in
companies that are well-positioned to benefit from the growth of the middle
class and consumer spending in these markets, such as those in the retail,
technology, and financial sectors.
However, investing in emerging markets carries a higher degree of risk than
investing in more established markets. These markets may be more volatile
and subject to political and economic instability, which can make it challenging
to assess the potential risks and returns of these investments. Investors who
are considering investing in emerging markets should carefully evaluate their
risk tolerance and diversification needs, and may consider working with a
financial advisor who has experience in these markets. Additionally, investors
may consider investing in a diversified portfolio of emerging market securities,
such as an exchange-traded fund (ETF) or mutual fund that tracks a broad
index of emerging market stocks, which can help to mitigate some of the
risks associated with investing in individual companies or sectors within these
markets.
11.3 GENERATING EFFICIENT FRONTIER

The efficient frontier is a set of optimal portfolios that offer the highest
expected return for a given level of risk, or the lowest risk for a given level of
expected return. It can be generated using the following steps:
1. Define the universe of assets: The first step is to define the universe of
assets that will be included in the analysis. This can include stocks, bonds,
commodities, and other assets.
2. Collect historical data: Collect historical data for the selected assets,
including their returns, volatility, and correlations. This data will be used
to calculate expected returns and risk for each asset and to create a
correlation matrix.
3. Calculate expected returns: Use historical data to calculate the expected
returns for each asset. This can be done using various methods, such as
the mean return or the capital asset pricing model (CAPM).
4. Calculate risk: Calculate the risk for each asset using historical data.
This can be done using various measures of risk, such as standard deviation
or beta.
5. Generate portfolio combinations: Generate portfolio combinations by
combining different assets in different proportions. This can be done using
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Portfolio Management a portfolio optimization tool or manually by selecting different weights
for each asset.
6. Calculate portfolio expected return and risk: Calculate the expected
return and risk for each portfolio combination using the expected returns
and risk of the individual assets and the correlation matrix.
7. Plot the efficient frontier: Plot the efficient frontier by graphing the
expected return versus the risk for each portfolio combination. The
efficient frontier will be the set of portfolios that offer the highest expected
return for a given level of risk, or the lowest risk for a given level of
expected return.
8. Select the optimal portfolio: Finally, select the optimal portfolio from
the efficient frontier based on your risk tolerance and investment
objectives.
Generating an efficient frontier involves a complex analysis of historical data
and requires a deep understanding of portfolio theory and optimization
techniques.
11.4 EFFICIENT SET

An efficient set is a continuous curve which, in turn, means that there are
infinite number of efficient portfolios. This poses a typical problem to the
investors. How can one determine the composition (i.e., combination of assets
and portfolio weights) of each of an infinite number of efficient portfolios?
Markowitz did contemplate this problem and, in a major breakthrough,
presented a solution algorithm based on ‘quadratic programming’ technique.
Constrained Minimization Problem
As we know, an efficient set can be determined by minimizing portfolio risk
(i.e., return variance) for any level of expected return. If we specify the return
at some level and minimize risk, we have one point (i.e., a portfolio) on the
efficient frontier. Thus, we need to solve the following constrained
minimization problem:
n n
Minimise variance ( Vp) = 6 6 xi xj Vij
i=1 j=1
Subjet to the constraints:
1) Expected return (Rp) is equal to some predetermined level Rp
2) The sum of the portfolio weights for all assets in the portfolio must be
equal to 1; ( 6xi = 1)
i=1
3) The portfolio weight assigned to any asset should be positive
(xi t 0, i = 1, ..., n). In other words, short sales are not allowed.
This is a quadratic programming problem because of the presence of terms like
x2j, and xi, xj in the objective function.
200
Lagrange Multipliers Technique Portfolio Selection
The above kind of non-linear minimization problem can be solved by applying

Lagrange Multipliers Technique. We will explain the procedure with a three-
assets case and using the following example data:
Equity Shares Monthly Expected Standard Deviation
Return (%) (%)
A 3.5 11
B 9.0 20
C 4.5 12
Variance-Covariance Matrix
A B C
A .012 .009 .007
B .009 .040 .014
C .007 .014 .014
Let us suppose that x 1, x 2 and x3 are the portfolio weights corresponding to
the equity shares of A, B and C respectively. The portfolio weights must add
to
x1 + x2 + x3 = 1
Let us further assume that our target expected rate of return (Rp) is 5 per cent.
With these assumptions, we have:
a) expected rate of return equation (i.e., the return constraint):
0.05 =.035 x1 +.09x2+.045 (1-x1 - x 2)
which on simplification yields
.1 x1-.045x2+.005=0
b) returns-variance of the portfolio:
2
(p)
= [x12 * 0.012] + [x22 * 0.04]+ [(1-x1-x2)20.014]+ [2 * .009 x1 x2]+ [2
* 0.007 x1 (1-x1-x2)] + [2 * 0.014 x2 (1-x1-x2)]
which on simplification can be written as
2
(p)
= [0.012 x1 2] + [0.04 x22] + [0.014 x1 ]+ [.004 x1 x2] + 0.014
2
(p ) p p
2 2
1 2 1 1 2 1
2
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Portfolio Management 1 2
1 1 1
2 1 2
1 2
Thus, for a target expected rate of return of 5 per cent, the ‘minimum variance’
set or ‘efficient portfolio’ will correspond to an allocation by 44.5 per cent of
the fund to A, 21 per cent to B, and the remaining to C. If we plug the portfolio
weights into the objective function, we find
V 2(p) =.0117
or
V 2(p) =.1089
is nonlinear, its slope changes continuously and so should ë .
Tracing the Efficient Frontier
The process discussed above can be repeated to find as many points as desired
on the efficient frontier, each time starting with a specified target expected
rate-of return. In actual practice, standard computer packages are available
which can find solutions quickly and accurately. For our example case of
three equity shares. Table 11.1 shows ten efficient portfolios identified by the
application of such a package.
Table 11.1: Ten Efficient Portfolios
Portfolio 1* 2 3* * 4 5 10
Expected Return (%) 3.9 4.5 5.0 5.6 6.2 6.7 7.3 7.9 8.4 9.0
Standard Deviation (%) 9.9 10.2 10.8 11.7 12.8 14.1 15.4 16.9 18.4 20.0
Composition (%):
A 58.6 50.4 44.5 37.7 31.3
B 0.0 10.7 21.0 33.0 44.2
C 41.4 38.9 34.5 29.3 24.5
Ashok Leyland 24.9 18.5 12.2 5.8 0.0
ACC 55.3 66.4 77.6 88.7 100.0
Grasim 19.8 15.1 10.2 5.5 0.0
202
* This is the ‘global minimum variance’ efficient portfolio. No other Portfolio Selection
portfolio offers lower level of risk than this.
** We have already illustrated the determination of this portfolio through
the application of Lagrange Multipliers Technique.
Once sufficient number of efficient portfolios are determined, it is a simple matter
for the computer, using its capability for graphics, to draw the graph of the efficient
set. Figure 11.1 shows the graph drawn by the computer package.
10.00
8.00
6.00
Return
4.00
2.00
0.00
2.00 7.00 12.00 17.00 22.00
Risk
Figure 11.1: Efficient Frontier
In this context, it would be interesting to know the concepts of ‘corner

portfolios’ as introduced by Markowitz. Any set of efficient portfolios can
be described in terms of still a smaller sub-set of efficient portfolios, which
Markowitz termed as ‘corner portfolios’. The distinguishing feature of two
adjacent corner portfolios is that:
(a) one portfolio will contain either all the assets which appear in the other,
plus one additional asset, or
(b) all but one of the assets which appear in the other.
Thus, while moving along the efficient frontier curve from one corner portfolio
to the next, portfolio weights will vary until either one asset drops out of the
portfolio or another enters. The point (or the portfolio) at which a change in
the composition of assets takes place marks a new corner portfolio. For
instance, portfolios numbered 1 and 4 in Table 11.1, may be considered as
corner portfolios.
An important property of corner portfolios is that any combination of two
adjacent corner portfolios will result in a portfolio that lies on the efficient
set between the two corner portfolios. For example, if an investor puts 30 per
cent of his or her available funds in the portfolio numbered 1 and 70 per cent
in the portfolio numbered 4 (see Table 11.1), then the resulting portfolio of
the following composition (or portfolio weights) will be another efficient
portfolio lying between the corner portfolios 1 and 4.
A : .30 x 58.6 +.70 x 37.7 =44.0%
B : .30 x 0.0 + .70 x 33.0 = 23.1%
C : .30 x 41.4 + .70 x 29.3 = 32.9 203
Portfolio Management Thus, a computer algorithm may be developed which first determines some
successive corner portfolios, and proceeds next to delineate a set of efficient
portfolios lying between every two adjacent corner portfolios. Each of these
portfolios will correspond to a dot in the return-risk space, which can be finally
connected to draw the graph of the efficient set.
Limitations of Markowitz’s Approach
It is easy to see that the Markowitz’s approach to trace efficient set is extremely
demanding in its input data needs and computation requirements. This has
been probably best expressed by Markowitz himself: “...it is reasonable to
ask security analysts to summarize their researches in 100 carefully considered
variances of returns. It is not reasonable, however, to ask for almost 5000
carefully and individually considered covariance’s”. Indeed, while analysts
and portfolio managers are accustomed to thinking about expected rates of
return, they are much less comfortable in assessing the possible ranges of
variation in their expectations, and are usually, not at all accustomed to
estimating covariance of returns among assets.
The problem is made more complex by the number of estimates of covariance
(or correlation) required. For a set of 200 shares, for example, we need to
compute [200 (200-1)/ 2] = 19,900 covariance. It is unlikely that the analysts
will be able to directly estimate such a staggering number of inputs. Obviously,
what we need is an alternate formula for portfolio variance, that lends itself
to easy computation even when we are dealing with a large set of assets.
However, an understanding of Markowitz process would sharpen your
understanding on the portfolio theory and management though you may not
use in your day to day life Markowitz method of portfolio construction for
stocks.
Activity 1
Define the following
i) Efficient set
............................................................................................................
............................................................................................................
............................................................................................................
ii) Lagrange Multipliers Technique
............................................................................................................
............................................................................................................
............................................................................................................
iii) Diversifiable Risk
............................................................................................................
............................................................................................................
............................................................................................................
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Portfolio Selection
11.5 SHARPE’S SINGLE-INDEX MODEL
We get such a capability with the ‘single-index model’ developed by a student
of Markowitz named William Sharpe (1963). In the 1950s, after techniques
for estimating the required inputs to this model were perfected, packaged,
and marketed as computer software, modern portfolio really took off in terms
of practical applications. Now the single-index model is widely employed to
allocate investments in the portfolio between individual equity shares, while
the original more general model of Markowitz is widely used to allocate
investments between types of assets, such as bonds, shares, and real estate. In
the discussion that follows, we present the basic tenets of the ‘single-index
model’, with reference to investment in equity shares.
The Assumptions and the Model
Essentially, the single-index model assumes that the returns of various
securities are related only through common relationships with some basic
underlying factor. In the words of Sharpe, this factor “may be the level of the
stock market as a whole, the gross national product, some price index, or any
other factor thought to be the most important single influence on the returns
from securities”. A casual observation of share-price movements, at least,
tends to support this line of argument. There is considerable evidence that
when the stock market goes down, most shares tend to decrease in price. For
instance, on the date of budget, several stocks move in the same direction
depending on the assessment of the budget on the economy and industry. It
appears, therefore, that one reason share returns might be correlated is because
of a common response to market changes as measured by the movements in,
say, share price index.
To understand the above assumption of the single-index model more precisely,
consider Figure 11.2, where we have related the returns of a hypothetical
share to the returns on the market index
Figure 11.2: ACC Return vs. Sensex Return
The line running through the scatter points is the ‘line of best fit’, or an estimate
of what is known as a share’s `characteristic line’. Algebraically, the
characteristic line can be defined as
Ri = Di + E i Rm Eq (1) 205
Portfolio Management where
Ri = the return of security i
Di = the components of share i’s return that is independent of the
market’s performance-a random variable;
Rm = the rate of return on market index-a random variable; and
E i (beta) = the slope. of the characteristic line that measures the expected
change in R, given a change in Rm
It is useful to break the term Ri , in two components:
1. Di (alpha), the expected value of ai ; and
2. ei, the random element with a Mean value of zero.
In terms of graphical presentation (see Figure 11.2) ei (or residuals, as they
are frequently referred to) measure vertical deviations from the characteristic
line. With this, equation (1) can now be written as
Ri =Di + E i Rm + ei Eq. (2)
where Rm and ei , (both random variables) are conveniently assumed to be not
correlated with each other.
It is further assumed that the residuals are not correlated across shares of
different companies; that is, ei, is independent of ei for all values of i and j.
This is an important assumption; it implies that the only reason shares vary
together, systematically, is because of a common co-movement with the
market. Thus, single-index model assumes away all other possible effects on
shares’ returns, such as industry effects.
Systematic Risk and Diversifiable (or Residual) Risk and Covariance of
Returns
With some manipulations of equation (2), we get the following important
results:
(a) the expected return, Ri =Dai + E i Rm
(b) the variance of share’s return, V 2i = E 2i V 2m + V 2ei where V 2m and V 2ei
variances of the distribution of Rm and ei, respectively; and
(c) covariance of returns between shares i and j, V = EEV2m
It is apparent from (a) above that the expected return has two components: a
unique or non-market part, a, and market related part, âi Rm. Even though
shares have many common characteristics and, as a result, tend to move
together, their numerous individual and distinguishing properties cause shares
to co-move with the market at different rates. Accordingly, how sensitive a
share’s price is to changes in the overall market i.e. the value of its ‘beta’ is of
great significance in determining the expected return.
Like the expected return, we can always split the variance of share’s returns
206 into two parts, as shown in (b) above. The first component E 2i V2m, is called
the ‘systematic risk’ or ‘market risk’ of the investment. Since V2m is the same Portfolio Selection
for all shares, systematic risks will differ among different shares accordingly
to the magnitudes of their ‘betas’, E i. Simply stated, beta measures sensitivity
of a share’s price movements compared with those of the market index. Shares
having betas less than 1 can be said to be ‘defensive’. One per cent increase
(decrease) in the market return is likely to be accompanied by a less than one
per cent increase (decrease) in the shares’ rate of return. The investors are
thus defended to some extent against the occurrence of major down fall in the
market return. On the other hand, shares with individual beta values greater
than one are considered to be more ‘aggressive’ or more risky, as one per cent
increase (decrease) in the market return is likely to be accompanied by an
even greater increase (decrease) in the shares’ rates of return. A beta of one
implies ‘average’ riskiness; every one per cent return on the market is
associated with one per cent opportunity return on the share. Beta can be
negative as well, reflecting that share prices can rise when the market falls
and vice versa; but this is normally unusual.
The systematic risk is caused by macro events like oil crisis, an unexpected
change in rate of inflation, etc. The macro events are broad and affect nearly
all shares to one degree or another, and they may have an impact on the general
level of stock market. Thus, one cannot reduce systematic risk by diversifying
investment across different shares. That is why the systematic risk is often
called ‘non-diversifiable’ risk.
The second component of variance of share’s returns, V2ei , is known as
‘residual variance’ or ‘unsystematic risk’ or ‘diversifiable risk’. The source
of this kind of risk is‘micro’ events, which have impact on individual shares
but no sweeping impact on other shares. Examples include the introduction
of a new product(s) or the sudden obsolescence of an old one. They might
also include labour strike lockout or the resignation or death of a key person
in the firm, or splitting up of a business family. Since micro events affect
only the individual shares under consideration, their impact can be reduced
to a great extent by holding a diversifiable portfolio. We will explain how
diversification of risk takes place after a while.
At this point, we may recall that under Markowitz model we are required to
compute covariance of returns for every pair of assets comprising the portfolio.
We have also observed that without having estimates of covariance, one cannot
compute the variance of portfolio returns. However, if the single-index model
is a valid description of the process generating shares returns, there is no
need for direct estimates of the covariance. All that we need to know are the
values of share betas and variance of returns on market index; the covariance
between any two shares i and j can next be obtained easily by employing the
relationship as noted above. Needless to say that the relationship is much less
demanding in terms of estimation procedure and computation time.
What is more amazing to note here is that the single-index model does not
require even the indirect estimates of covariance of returns between shares.
The model provides a still simpler formula for computing variance of portfolio
returns. We will now explain this.
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Portfolio Management Variance of Portfolio Returns
We begin by restating that the total risk or variance of returns on share `i' is given by
σ2i = βi 2
m + 2
ei (11.3)
Total variance = Systematic Risk + Residual variance
This equation holds-for a portfolio of shares as well. Rewriting the equation for a
portfolio, we get
σ2i = β2 p σ2 m + σ2 ep (11.4)
Total Portfolio variance = Portfolio Systematic Risk + Portfolio residual variance
Where the subscript `p' denotes a portfolio.
It can be further shown that
n
βp = ∑xβ
i=1
i i
Portfolio Beta = Weighted average of individual share betas

and,
n
σ2ep = ∑ x 2i 2
ei
i=1
Portfolio residual variance = Weighted average of individual residual variances

Where weights are squared.
To illustrate the above formula of portfolio variance, let us consider the
following two shares:
Share Beta Residual Variance
A 0.54 98.2
C 1.13 62.7
Suppose, an investor is planning to put equal amounts of her/his investible
fund in these two shares. Then we have
Ep = 0.54 x.50+1.13 x -.50=0.56
V2ep = [98.2 x (.5)2] + [62.7 x (.5)2] = 40.2
If V2ep is equal to 81.0 per cent, the variance of the returns of the portfolio
under consideration will be given by
V 2p = (.56)2x 81.0 +40.2 =65.6
Vp = 8.1%
Let us now add one more share to the above portfolio, say, the share of ACC
with a beta of 1.63 and residual variance of 179.6 per cent. Suppose, the
investor decides once again to invest equal amount. This time whereas V2,
will be 37.8 per cent. Vp will work out to be 11.7 percent, whereas V2ep will be
37.8 percent.
It is interesting to note that while the portfolio’s systematic risk component
(E p) has increased due to the addition of a more risky share, its non-market
related risk component has declined. Given the single-index model’s
208 assumption that residuals (ei’s) of different shares are not correlated (we have
already explained this assumption), it is not difficult to appreciate how a Portfolio Selection
portfolio’s residual variance begins to diminish as the number of shares (n) in
the portfolio is increased. Assume for a moment that an investor forms a
portfolio by placing equal amounts of his funds into each of n shares. Equation
(11.6) then becomes
ª1º n ª1º 2
Vep
2
«¬ n »¼ ¦ V ei
i 1«
¬ n »¼
where the term within the bracket denotes average residual variance of the
shares comprising the portfolio. As the number of shares in the portfolio gets
large, portfolio’s average residual variance falls so rapidly that most of it is
effectively eliminated even for moderately sized portfolios.
At this stage, it would be appropriate to contrast the procedure for computing
portfolio variance as outlined above with that of the Markowitz model. We
have mentioned earlier that for a portfolio of 200 shares, Markowitz model
requires 19,900 estimates of covariance. Under the single-index model we
need, however, only 200 estimates of beta, 200 estimates of residual variance,
and one estimate for the variance of returns on market index. Indeed, this is a
dramatic reduction in the input data for computing portfolio variance.
But how accurate is the portfolio variance estimate as provided by the single-
index model’s simplified formula? If it is the Markowitz formula, we know
that the variance number of perfectly accurate, given, of course, the accuracy
of the covariance estimates. Besides, the formula makes no assumptions
regarding the return generating process. On the other hand, the single-index
model assumes that the market factor solely determines the shares’ returns
and residuals. are not correlated across different shares? Thus, the accuracy
of the single-index model’s formula for portfolio variance is as good as the
accuracy of underlying assumptions. Quite obviously, the assumptions are
not strictly accurate. Many researchers have found that there are influences
beyond the market that cause shares to move together. In addition, empirical
evidence suggests that residuals are correlated to some degree, which is not
altogether unexpected. After all, if something (good or bad) happens to a
company, some other companies, such as its suppliers and competitors, would
be affected simultaneously. The residuals that appear for the shares of these
other company would not, therefore, be independent of each other. However,
one can always expect that the degree of correlation would not be large enough
to impair the relative efficiency with which the single-index model estimates
the portfolio variance.
Activity 2
i) List out two major points of difference between Markowitz’s approach
and Sharpe’s single-Index Model of selecting optimal portfolio.
..............................................................................................................
..............................................................................................................
..............................................................................................................
..............................................................................................................
209
ii) List out relevant data for computing beta of an equity share.
..............................................................................................................
..............................................................................................................
..............................................................................................................
..............................................................................................................
iii) Try, to compute beta of an equity share of your choice.
..............................................................................................................
..............................................................................................................
..............................................................................................................
..............................................................................................................
11.6 OTHER PORTFOLIO SELECTION MODELS

So far we have considered investment in risky assets like equities. However,
an investor can also invest in ‘risk-free assets such as ‘treasury bills’ or
‘government securities’. Besides, in our analysis the investor is not allowed
to use borrowed money to invest in a portfolio of assets. This means that the
investor is not allowed to use financial leverage. If we take into account these
new opportunities to the investor, we will notice a major impact on the shape
and location of the efficient set.
We now take a note of some other portfolio selection models that seem to
hold great promises to practical applications. One such model is the ‘multi-
index model’. There are different variants of this model and each of them is
developed to capture some of the non-market influences that cause shares to
move together (recall that single-index model accounts for only market related
influences). The non-market influences, in essence, include a set of economic
factors or industry characteristics that account for common movement in share
prices. While it is easy to find a set of indices that are associated with non-
market effects over any period of time, it is quite another matter to find a set
that is successful in predicting covariance that are not market related. There
is still a great deal of work to be done before multi-index models consistently
outperform the simpler one.
Another model that takes into account a wide spectrum of practical
considerations in portfolio selection is the goal-programming model. In real
life, an investor’s goals and desires transcend. the notion of a trade-off between
only risk and return. For example, an investor may prefer to invest some
minimum amount in several different shares, but at the same time he or she
may not like individual investment to exceed a specified limit. Additionally,
s/he may prefer dividend income to capital appreciation. There may also be a
desire not to allow the portfolio beta to be either above or below a
predetermined level. Apart from holding such diverse goals and desires, the
210 investor may even set the order of their priorities. In this kind of investment
problem situation, the goal-programming model is ideally suited to provide Portfolio Selection
an optimal solution. Further goal programming solution can be easily obtained
by available computer packages.
11.7 SUMMARY
This unit provides some insights into Markowitz’s approach to trace the
efficient set. The application of Markowitz’s model requires estimation of
large number of covariance. And without having estimates of covariance, one
cannot compute the variance of portfolio returns. This makes the task of
delineating efficient set extremely difficult. However, William Sharpe’s
‘single-index model’ simplifies the task to a great extent. Even with a large
population of assets from which to select portfolios, the number of required
estimates are amazingly less than what are required in Markowitz’s model.
But how accurate is the portfolio variance estimate as provided by the single-
index model’s simplified formula? While the Markowitz’s model makes no
assumption regarding the source of the covariance, the single-index model
does. Obviously, the accuracy of the latter model’s formula for portfolio
variance is as good as the accuracy of its underlying assumption.
We have also discussed in brief other portfolio selection models, such as ‘multi-
index model’ and ‘goal programming model’ which have high intuitive appeal
but would require much more work before they outperform the simple ones.
11.8 KEY WORDS

Corner Portfolio : is an efficient portfolio to having any combination
of two feasible solution.
Goal Programming : is a technique to solve optimization problems with
multiple goals.
Lagrange Multipliers : is a technique of solving non-linear optimization
Technique problems.
Market-Index : refers to the ultimate market index.
(or Market Portfolio)
Multi-Index Model : purports to explain the covariance that exist
between assets on the basis of changes over time
in two or more indices.
Single-Index Model : purports to explain the covariance, which exist
between the returns on different assets on the basis
of the relationship between the returns and a single
index, usually the market index.

1. Explain in your own words the following:
a) Significance of ‘corner portfolios’
211
Portfolio Management b) Major limitations of Markowitz model
c) Key assumptions of the Single-Index model
2. Explain how a portfolio’s residual variance begins to diminish as the
number of assets in the portfolio is increased?

Alexander, Gordon J. and Sharpe, William F., and Jeffery V. Bailay. (1990).
Fundamentals of Investments, 3rd Edn., Prentice-Hall. Inc.
McGraw Hill.
Haugen. Robet A. (1990) Modern Investment Theory, 5th Edn., Prentice-Hall
International,Inc.
IIT Kharagpur [nptelhrd]. (2012). Mod-01 Lec-26 Multifactor Pricing Model
[Video]. YouTube. https://www.youtube.com/watch?v=Pjt5al64UI4
IIT Kharagpur [nptelhrd]. (2012). Mod-01 Lec-28 Other Optimal Portfolio
Selection Models [Video]. YouTube. https://www.youtube.com/
watch?v=dzO1mO7otFM
Chand & Sons.
Singh, J. P., [IIT Roorkee]. (2021). Lecture 49: Single Index Model I [Video].
YouTube. https://www.youtube.com/watch?v=OK5MYa36gNM
Singh, J. P., [IIT Roorkee]. (2021). Lecture 50: Single Index Model II [Video].
YouTube. https://www.youtube.com/watch?v=-Lgh4-5ptY8
212
Portfolio Selection
UNIT 12 CAPITAL MARKET THEORY
Objectives
After studying this unit, you should be able to:
• Understand the concept of Capital Asset Pricing Model (CAPM) define
risk free asset, risk free lending, risk free borrowing and leveraged
portfolio;
• Discuss and illustrate the implications of leveraged portfolio for efficient
set and Capital Market Line (CML);
• Explain the Security Market Line(SML) ;
• Highlight limitations of CAPM and describe alternative theory namely
Arbitrage Pricing Theory (APT) Structure.
Structure
12.1 Introduction
12.2 Risk free assets
12.3 Efficient set with risk free lending and borrowing
12.4 Capital Asset Pricing Model (CAPM)
12.5 Arbitrage pricing theory
12.6 Summary
12.7 Key words
12.1 INTRODUCTION
Capital Market Theory sets the environment in which securities analysis is
preformed. Without a well-constructed view of modem capital markets,
securities analysis may be a futile activity. A great debate, and great divide,
separates the academics, with their efficient market hypothesis, and the
practitioners, with their views of market inefficiency. Although the debate
appears surreal and unimportant at times, its resolution is immensely critical
for conducting effective securities analysis and investing successfully. The
CAPM is commonly confused with portfolio theory. Portfolio theory is simply
the use of statistical and mathematical programming techniques to derive
optimal tradeoffs between risk and return. Under very restrictive assumptions
(rarely found in financial markets), the CAPM is a highly specialized subset
of portfolio theory. Even so, the CAPM has become very popular as it provides
a logical, common sense tradeoff between risk and return. In this unit, our
endeavor will be to extend the portfolio theory described in the previous two
units, to the capital market theory that is concerned with pricing risky assets.
213
Portfolio Management In particular, we would like to know if two assets differ with respect to their
risk, how will they differ in terms of the price investors are willing to pay or
the rate of return investors expect to get from them. The original SLM version
of the CAPM still remains the central theme in capital market theory as well
as in current practices of investment management.
12.2 RISK-FREE ASSET

Risk-free asset is an asset, which has a certain future return. In other words, a
risk-free asset is one for which there is no uncertainty regarding the future
returns; that is, the investor knows exactly what the value of the asset will be
at the end of the holding period. Thus, variance of returns of a risk-free asset
is equal to zero. A good example of such asset is government bonds.
Whether all types of government bonds are risk-free asset? It is difficult to
say because long-term government bonds are exposed to certain types of risk
like interest rate risk and inflation risk. For instance, if the maturity period of
a government security is (say) 15 years, while the investment horizon (or the
holding period) of an investor is (say) three- months, then the investor does
not really know at what market price he will be able to sell the security at the
end of his holding period. Any change in interest-rate structure during the
holding period will-influence the market price of the security. To give an
idea, upward revision of interest rate will have a tendency to lower the market
price, such that yield-to-maturity at market-price-based acquisition of the
security of given maturity period compares well with the yield-to-maturity of
new issue with similar maturity period. This is an example of what is termed
as ‘interest-rate-risk’. Thus, normally, the short-term government securities
like Treasury Bills are called risk-free securities. Can corporate debentures
be treated as risk-free asset? Certainly not, because risk of default is associated
with them in addition to interest rate risk and inflation risk. In fact, corporate
bonds have more risk like liquidity risk. However, in relative term, they are
better than equity on risk.
What is the co-movement of returns of risk-free asset and risky asset (or
portfolio of risky assets)? Interestingly, it is always zero. We may recall that
covariance between returns of two-assets ‘i’ and ‘j’ are given by
σij = Uij σi σi
where Uij , σi , σi are the correlation co-efficient and standard deviation of returns
on assets ‘i’ and `j’ respectively. If one of the assets is risk-free asset, say
asset `i’, then by definition returns on risk-free asset are certain such that the
standard deviation (σi) iszero and hence the co-variance (σij) is also zero.
These two characteristics of risk-free asset, namely, (a) variance = 0; and (b)
covariance of returns with any other asset = 0, are quite significant in
determining the shape of efficient frontier.
Risk-Free Lending and Borrowing
Investing in a risk-free asset is frequently referred to as ‘risk-free lending’,
since investment in such assets tantamount to giving loan directly to the
214
government. An investor does not have to depend solely on his own wealth to Capital Market Theory
decide how much to invest in assets. She/he can borrow and invest, i.e., the
investor can use financial leverage. However, investor will have to pay interest
on borrowed funds and such borrowing is also assumed to have same risk-
free interest rate and hence deemed as “risk-free borrowing”. Though it may
not be practical for an ordinary investor to borrow at risk-free interest rate, it
is quiet possible for large funds to borrow at a rate close to risk-free rate.
EFFICIENT SET WITH RISK-FREE LEADING AND BORROWING
The efficient frontier consists of only risky securities. What happens to the
average rate of return and standard deviation of returns when a risk-free asset
is combined with a portfolio of risky assets such as exists on the Markowitz
efficient frontier?
Unit 10. The efficient frontier consists of only risky securities. What happens
to the average mte of return and standard deviation of returns when a risk-
free asset is combined with a portfolio of risky assets such as exists on the
Markowitz efficient frontier?
The expected portfolio return (Rp is given by
Rp = XRf + (l - x) R1 (12.1)
where,
x = the proportion of the portfolio invested in a risk free asset;
Rf = risk-free mte of return; and
Ri = expected return on risky portfolio i’
Recalling equation (10.2), variance of returns for two-asset poitfolio (V2p) is
as follows:
V2 = [x 2 V2f] + [(1- x)2 V2] + [2 x (1 - x)V if] (12.2a)
Where, V2f and V2i are the return variances of risk-free asset and risky portfo-
lio respectively, and V if is the covariance of returns between risk-free asset
and portfolio of risky assets i.
As we have noted earlier, for risk-free asset variance and covariance tenns
are Zero, i.e., V2f = 0 and V if = 0; and so equation (12.2a) retains only the
middle tens and reduces to
V2P = (1 - x)2 V2i
V2P = (1 - x) Vi (12.2b)
As the equations (12.1) and (12.2b) are both linear, the returns-risk graph for
portfolio possibilities, combining the risk-free asset and risky portfolios on
Markowitz efficient frontier, is represented by a straight line. Figure 12.1
illustrates the position.
215
Return
Risk
Figure 12.1: Efficient Set of Portfolios with Risk-Free Asset
The set of efficient portfolios marked in the curve A, B, M, C, and D are set
of portfolios consisting of risky assets. Suppose there is a risk-free asset
offering a return of Rf Now compare an investment in the portfolio of A
(consisting of risky assets) and investment in risk-free security. Investment
in risk-free security offers a return higher than A but without any risk. Thus,
investment in risk-free security is superior to investments in A and in that
process A become inefficient portfolio. A tangent line drawn from Rf through
the curve A-B-M-C-D is now become efficient portfolio. You may note that
only one portfolio marked ‘M’, which consists of risky assets falls under the
new efficient frontier. Such portfolio is called ‘market portfolio’ which consists
of all risky assets. Investors can now earn any return they like on the efficient
frontier by investing a part of money in M, and the rest in Rf For instance, an
investor, who is willing to take maximum risk, will invest entire wealth in M
whereas an investor, who dislike risk invest the entire wealth in Rf an investor
with moderate risk preference will invest 50% in Rf and the balance 50% in
M. An investor, who want to go beyond M has to borrow at risk-free rate of
interest and invest the amount in M and capture the difference between M
and Rf to increase the return.
OPTIONAL PORTFOLIO SELECTION
Leveraged Portfolio
In the foregoing analysis it has been tacitly assumed that investors holding
portfolios by combining risk-free asset and risky portfolio M, do so with their
own funds. This is not a realistic assumption. In the real world, investors
often purchase assets with borrowed funds. We now explore the implications
of borrowing.
Assume that an investor is, of course, ready to accept higher level of risk,
216
i.e., the investor is willing to hold portfolio with expected standard deviation Capital Market Theory
of returns σp greater than σm . One alternative would be to choose a portfolio
of risky assets on Markowitz efficient frontier beyond M, such as the one at
point C. A second alternative is to borrow money (i.e., add financial leverage)
at risk-free rate and invest the same in the risky asset portfolio at M. By
doing so, the investor can move from point M to, say, point Q along the
extension of Rf to M line. And as is evident from figure 12.1, such portfolios
as at Q dominate all portfolios below the line, including the portfolio at C.
To illustrate the point, let us assume that investors can borrow, whatever
amount they wants, at a risk-free rate. In other words, we are assuming that
risk-free lending and risk-free borrowing rates are the same (we will see the
implication of relaxing this assumption later). We may further note that
investors would not desire to simultaneously invest in risk-free asset and
borrow money at risk-free rate. Now, suppose that an investor borrows an
amount equal to 50 per cent of his original wealth of, say, ` 10,000. So s/he
has total of ` 15,000 which he proposes to invest in portfolio M. What is the
proportion of fund being invested in M? It is given by
1 - x = 15,000/10,000= 1.5
However, the sum of proportions being invested in risk-free assets and M
must still equal one, which means that x = -5,000/10,000= -0.5
The negative sign indicates borrowing, on which there will be interest payment
at Rf. Thus, restating equation (12.1), we have
RP = -0.5Rf + 1.5Rm
Assuming that Rf. = 8% and Rm = 20%, the return on the leveraged portfolio
will be = - 0.5 (.08) + 1.5 (0.20) = 0.26 or 26 per cent which is significantly
higher than Rm , the expected return of 20 per cent on risky portfolio M.
Using equation (12.2b), the standard deviation of returns from leveraged
portfolio works out to
σp = (1- (-.5)) σm = 1.5 σm
Thus, our investor could increase return along the line Rf - M - Q. Herein lies
the advantage of owning a ‘leveraged’ portfolio. However, leveraging also
involves a trade-off; the risk of a leveraged portfolio is always higher than
that of tangency portfolio, M (in the instant case it is 1.5 times).
Capital Market Line (CML)
With the identification of M as market portfolio, we may define the straight
line from Rf through M, as ‘capital market line’ (CML). This line represents
the risk premium as a result of taking on extra risk. James Tobin added the
notion of leverage to Modern Portfolio Theory by incorporating into the
analysis an asset, which pays a risk-free rate of return. By combining a risk-
free asset with risky assets, it is possible to construct portfolios whose risk-
return profiles are superior to those of portfolios on the efficient frontier (figure
12.2).
217
Portfolio Management 15%
Risk-Free
Rate
10%
5%
0%
-5%
0% 5% 10% 15% 20%
Figure 12.2: Capital Market Line
Risk (Return Volatility)

The capital market line is the tangent line to the efficient frontier that passes
through the risk free rate on the expected return axis.
The risk-free rate is assumed to be 5%, and a tangent line-called the capital
market line-has been drawn to the efficient frontier passing through the risk-
free rate. The point of tangency corresponds to a portfolio on the efficient
frontier. That portfolio is called the “super efficient” portfolio. The Capital
Asset Pricing Model demonstrates that, given certain simplifying assumptions,
the super-efficient portfolio must be the market portfolio.
Using the risk-free asset, investors who hold the super-efficient portfolio may:
x Leverage their position by shorting the risk-free asset and investing the
proceeds in additional holdings in the super-efficient portfolio, or
x Deleverage their position by selling some of their holdings in the super-
efficient portfolio and investing the proceeds in the risk-free asset.
All types of investors, whether aggressive or conservative, will achieve their
desired risk-return levels by combining market portfolio with risk-free lending
or borrowing along the CML. Let us re-examine the equation (12.3) of the
capital market line to make a few more observations at this stage.
The term (rm - rm ) /m, the slope of capital market line, can be thought of as the
market price of risk for all efficient portfolios. It is extra return that can be
gained by increasing the level of risk (standard deviation) on an efficient
portfolio by one unit. Thus, the entire second term of equation (12.3) represents
that element of expected portfolio return that compensates for the risk level
accepted. The first term, risk-free rate (or the intercept of CML), is often
referred to as the reward for waiting or the return required for delaying
potential consumption for one period.
With these two terms, CML sets the expected return on an efficient portfolio
as
218 (Price of time) + [(Price of risk) x (Amount of risk)]

When Risk-Free Rates are different Capital Market Theory
In the foregoing discussion we assumed that risk-free rates of lending and

borrowing are the same. We now relax this assumption, and consider that
where the additional subscripts B and L refer to borrowing and lending
respectively.
Figure 12.3 shows the modified efficient set; it consists of three distinct but
connected segments, RfL - ML - MB – B.
Figure 12.3: Efficient Set of Portfolios with different Risk-free rates
The construction of this efficient set can be explained as follows: If R fL = RfB,

then the resulting efficient set will be given by the straight line from RfL through
ML. On the other hand, if risk-free lending and borrowings rates are the same,
but the rate is set at a higher level equal to RfB, then the efficient set of portfolios
will lie on the straight line from RfB through MB. We may note that MB is at a
higher level than ML on Markowitz’s efficient set, since it corresponds to a
tangency point associated with higher risk-free rate, RfB.
Now, since the investor cannot borrow at RfL, that part of the line emanating
from RfL that extends past ML is not available to the investors (shown in Figure
12.3 by dotted lines) and can be removed from our consideration. Again, since
the investors cannot invest in a risk-free asset that earns a rate equal to RfB,
that part of the line from RfB and going through MB, but lying to the left of MB,
is not available to the investors; and, hence, can be ignored. On the whole,
RfL - ML - MB - B becomes the relevant efficient set to investors who can lend
at RfL and borrow at RfB.
12.4 CAPITAL ASSET PRICING MODEL (CAPM)

In this section, we turn to the basic Capital Asset Pricing Model developed
by Sharpe, Linter and Mossin. We present here a descriptive model of how
assets are priced.
The CAPM model describes the relationship between risk and expected return,
and serves as a model for the pricing of risky securities. CAPM says that the
expected return of a security or a portfolio equals the rate on a risk-free security
219
Portfolio Management plus a risk premium. If this expected return does not meet or beat required
return then the investment should not be undertaken.
The CAPM builds upon the Markowitz portfolio model and capital market
line. Obviously, it pre-supposes all the assumptions stated earlier at appropriate
places. Besides, the model itself adds few more assumptions. So, let us begin
our discussion of the CAPM by putting together all the assumptions of the
model at one place.
Assumptions
x Investors evaluate portfolios by looking at expected returns and standard
deviations of those portfolios over a one-period horizon.
x Investors, when given a choice, between two otherwise identical portfolios,
will choose the one with higher expected return.
x Investors, when given a choice, between two otherwise identical portfolios,
will choose the one with the lower standard deviation or risk.
x Individual assets are infinitely divisible, meaning that an investor can
buy a fraction of a share if he or she so desires.
x There is a risk-free rate at which an investor may either lend money or
borrow money.
x Taxes and transaction costs are irrelevant.
x All investors have the same one-period horizon.
x The risk-free rate is the same for all investors.
x Information is freely and instantly available to all investors.
x Investors have homogeneous expectations, meaning that they have the
same perceptions in regard to the expected returns, standard deviations
and covariance of returns between any two assets.
Needless to say, many of these assumptions are unrealistic, and one may very
well wonder how useful a model can be that is based on them. But, then
assumptions are necessary in building a model, and we should not be so much
concerned about the assumptions as we should be about how well the model
explains the relationships that exist in the real world. In fact, several authors
have shown that many of the above assumptions can be relaxed with minor
impact on the CAPM and no change in the overall concept of the model.
Security Market Line (SML)
Given the capital market line (CML) and the dominance of the market
portfolio, the relevant risk measure for an individual risky asset is its
covariance with the market portfolio (Covi,M), or what is known as its
‘systematic risk’. When this covariance is standardized by the covariance for
the market portfolio, we obtain the well-known ‘beta’ measure. of systematic
risk and a security market line (SML) that relates the expected return for an
asset to its beta. Under the CAPM, the postulated relationship is such that
higher an asset’s beta, the higher its expected return.
220
To understand the CAPM and computation of beta, let us examine the whole Capital Market Theory
issue intuitively. If the concept of CML is clear, you will agree that it is not
possible for any stock to offer a risk-return relationship below or above the
CML. If it is below the CML, such stocks are known as overpriced stocks
(meaning they offer lower return for a given level of risk and there is an
alternative portfolio on the line of CML, which offer higher return) and
investors will start selling the stock until its return increases to the level of
CML. The same applies if there is a stock above CML in terms of risk and
return and investors will buy such stocks by offering higher price until its
return declines to CML. In CML, you can observe only two points namely Rf
and M. Since M is an efficient portfolio, we assume that the risk associated
with the M is the least. Suppose a stock lies beyond M in the CML line and it
means that the stock’s risk is higher and hence offer higher return. Now, it is
possible to quantify how much that the stock is riskier than M and such a
measure is called beta of the stock. If the stock falls on the CML line, it’s
return (Rs) should satisfy the following equation.
Rs = Rf + βs (Rm - Rf )
where β = σ / σm2
The term βs , representing covariance of returns between asset ‘s’ and the market
portfolio divided by return variance of market portfolio, is known as “beta co-
efficient” or simply “beta” for asset. The above equation is the most often written
form of the CAPM. If the beta and expected return of stocks are plotted, the line
that shows the risk and return of all stocks in the market is called security market
line (SLM). Let us now examine some properties of beta.
Beta is a means of measuring the volatility of a security or portfolio of
securities in comparison with the market as a whole. Beta is calculated using
regression analysis.
Beta of 1 indicates that the security’s price will move with the market. Beta
of greater than 1 indicates that the security’s price will be more volatile than
the market. Beta less than 1 means that it will be less volatile than the market.
Many Utilities stocks have a beta of less than 1. Conversely most high-tech
stocks have a beta greater than one, they offer a higher rate of return but they
are also very risky. For example, if a stock’s beta is 1.2, it’s 20% more volatile
than the market. Beta is a good indicator of how risky a stock is. Beta is the
sensitivity of a stock’s returns in comparison to the returns on some market
index (e.g., BSE Sensex, NSE- 50 or BSE-100).
Beta values can be roughly characterized as follows:
1. β less than 0
Negative beta is possible but not likely. People thought gold should have
negative betas but that hasn’t been true.
2. β equal to 0
Cash under your mattress, assuming no inflation or any investments with
a guaranteed constant return. 221
Portfolio Management 3. β between 0 and 1
Low-volatility investments (e.g., Utility stocks)
4. β equal to 1
Matching the index (e.g., any index fund offered by mutual funds)
5. β greater than 1
Anything more volatile than the index (e.g., small cap. funds)
6. β much greater than 1 (tending toward infinity)
Impossible, because the stock would be expected to go to zero on any
market decline. Beta of 2-3 is probably as high as you will get.
More interesting is the idea that securities may have different betas in up and
down markets.
Here is an example showing the inner details of the beta calculation process:
Suppose we collected end-of-the-month prices and any dividends for a stock
and the BSE sensitive index for 61 months (0 to 60). We need n + 1 price
observations to calculate n holding period returns, so since we would like to
index the returns as 1 to 60, the prices are indexed 0 to 60. Also, professional
beta services use monthly data over a five-year period.
Now, calculate monthly holding period returns using the prices and dividends.
For example, the return for month 2 will be calculated as:
R2 = (P2- P1+ D2) / P1
Here R denotes return, P denotes price, and D denotes dividend.
The following table of monthly data may help in visualizing the process.
(Monthly data is preferred in the profession because investors’ horizons are
said to be monthly.)
Sl. No. Date Price Dividend’ Return
0 31/12/20 45.20 0.0
0
1 31/01/20 47.00 0.0 0.0398
0
2 28/02/20 46.75 0.30 0.0011
0
.... ...... ....... ..... .....
59 30/11/22 46.75 0.30 0.0011
2
60 31/12/22 48.00 0.00 0.0267
2
Note: (*) Dividend refers to the dividend paid during the period. They are
assumed to be paid on the date. For example, the dividend of 0.30
could have been paid between 01/02/23 and 28/02/023, but is
222 assumed to be paid on 28.02.23.
So now we’ll have a series of 60 returns on the stock and the index (1 to 61). Capital Market Theory
Plot the returns on a graph and fit the best-fit line (visually or using least
squares process).
If you had a portfolio of beta 1.2, and decided to add a stock with beta 1.5,
then you know that you are slightly increasing the riskiness (and average
return) of your portfolio. This conclusion is reached by merely comparing
two numbers (1.2 and 1.5). That parsimony of computation is the major
contribution of the notion of “beta”. Conversely if you got cold feet about the
variability of your beta = 1.2 portfolio, you could augment it with a few
companies with beta less than 1. If you had wished to figure such conclusions
without the notion of beta, you would have had to deal with large covariance
matrices and nontrivial computations.
Hence, beta is the relevant measure of risk for an asset; it measures what is
termed as ‘systematic or market risk’. It can be shown that the ‘total risk’ of
the asset, as measured by variance of its return, is of the following form
V 2i = E 2 i V 2m
where
V2, is the variance of return for the asset that is not related to the market
portfolio. It is also said to measure ‘unsystematic or unique risk’. We know
that unique or unsystematic risk can be eliminated in a completely diversified
portfolio such as the market portfolio. So, unsystematic risk is not relevant to
investors, and they should not expect to receive added returns for assuming
this risk. It is only in the case of assets with greater market risk or betas that
investors should expect higher return.
Second, beta of a portfolio is simply a weighted average of the betas of its
component assets (n) where the proportions invested in the assets (x i) are the
weights. Thus, portfolio beta (E p) is given by
we may illustrate this point by taking a stock portfolio comprising seven stocks
with their betas and portfolio proportions given as follows:
(1) (2) (3) (4)
Company Beta PORTFOLIO PROPORTIONS WEIGHTED BETA
A 1.50 11.7 .175
B 1.36 22.2 .302
C 1.37 15.7 .215
D 1.07 5.3 .056
E 1.17 26.2 .306
F 1.73 13.9 .240
G 1.09 5.1 .055
100.0 1.349
223
Portfolio Management The beta of this stock portfolio is 1.35, which is obtained by summing up the
multiproduct of (2) and (3) above and shown under (4). It is easy to see the
central role played by the beta in the determination of expected return and
risk for stocks as well as portfolio and thus in stock selection and portfolio
creation and revision.
Limitations
You may be now interested in knowing whether security returns is in fact
directly related to beta, as the CAPM asserts. Research results suggest that
the CAPM does not reflect the world well at least when tested using ex-post
data. Critics have pointed out that the inadequacy of the model is due to its
austerity. The market, in principle includes all stocks, a variety of other
financial instruments, and even non-marketable assets such as an individual’s
investment in education; to which no market index like the SP 500 Index in
US or Bombay Stock Exchange National Index (or any other index used to
represent the market) can be a perfect proxy. And when we measure market
risk using an imperfect proxy, we may obtain a quite imperfect estimate of
market sensitivity. Secondly, the CAPM asserts that only a single number-
market return - is required to measure risk. The actual returns depend upon a
variety of anticipated an unanticipated events. Thus, while systematic factors
are the major sources of risk in portfolio return, different portfolios have
different sensitivities to these factors. It is the recognition of this phenomenon
which lies at the core of an alternative-pricing model called Arbitrage Pricing
Theory (APT). Let us briefly discuss APT in the following section.
12.5 ARBITRAGE PRICING THEORY

The core of Arbitrage Pricing Theory (APT) is the recognition that several
systematic factors affect security returns. It is possible to see that the actual
return, R, on any security or portfolio may be broken down into three
constituent parts, as follows:
R=E + bf + e
where:
E = expected return on the security
b = security’s sensitivity to change in the systematic factor
f = the actual return on the systematic factor
e = returns on the unsystematic factors
The above equation merely states that the actual return equals the expected
return, plus factor sensitivity times factor movement, plus residual risk. The
subtler rationale and mathematics of APT are left out here. The empirical
work suggests that a three or four - factor model adequately captures the
influence of systematic factors on stock - market returns. The APT Equation
may thus be expanded to:
R = E + (b1) (f1) + (b2) (f2) + (b3) (f3) + (b4) (f4) + e
224
Each of the four middle terms in this equation is the product of the returns on Capital Market Theory
a particular economic factor and the given stock’s sensitivity to that factor.
What are these factors and separating unanticipated from anticipated factor
movements in the measurement of sensitivities is perhaps the biggest problem
in APT.? Some of the factors empirically found to be useful in measuring risk
are:
x Changes in expected inflation, unanticipated changes in inflation,
industrial production, default-risk premium and term structure of interest
rates;
x Default risk, term structure of interest rates, inflation, long term expected
growth rate of profits for the economy, and residual market risk.
It may be noted that CAPM and APT are different variants of the true
equilibrium pricing model. Both are, therefore, useful in supplying intuition
into the way security prices and equilibrium returns are established.
Activity 1
What do the following stand for:
CAPM .................................................................................................
.................................................................................................
.................................................................................................
CML .................................................................................................
.................................................................................................
.................................................................................................
SML .................................................................................................
.................................................................................................
.................................................................................................
SLM .................................................................................................
.................................................................................................
.................................................................................................
APT .................................................................................................
.................................................................................................
.................................................................................................
12.6 SUMMARY
In this unit, we have discussed the basic levels and assumptions of Capital
Asset Pricing Model (CAPM). The Concepts of risk free asset, risk free
lending, risk free borrowing, leveraged portfolio, market Portfolio, Capital
Market Line (CML), Security Market Line (SML) and beta have been
explained and illustrated at length. This unit also pinpoints the limitations
CAPM and introduces arbitrage pricing theory (APT) and concludes that till
225
Portfolio Management concrete research results become available to the contrary, both CAPM and
APT could be regarded useful, at least intuitively, to guide investors and
portfolio managers for pricing the risky assets like equities.
12.7 KEY WORDS

Arbitrage pricing theory : is a multi-factor asset pricing model based
on the idea that an asset’s returns can be
predicted using the linear relationship
between the asset’s expected return and a
number of macroeconomic variables that
capture systematic risk.
Beta : is a measure of the volatility–or systematic
risk–of a security or portfolio compared to
the market as a whole.
Capital Asset Pricing Model : is a financial model that calculates the
expected rate of return for an asset or
investment.
Capital Market Line : represents portfolios that optimally combine
risk and return.
Security Market Line : a line drawn on a chart that serves as a
graphical representation of the capital asset
pricing model (CAPM).

1. Define risk free asset. List out two risk free assets.
2. Compare and contrast Capital Market Line (CML) and Security Market
Line (SML).
3. What are the basic assumptions underlying Capital Asset Pricing Model?
4. Define efficient frontier. What happens to the Capital Market Line and
the choice of an optimal portfolio if borrowing rate is allowed to exceed
the lending rate?
5. Define leveraged portfolio and bring out its implications for capital market
line.
6. Compare and contrast CAPM and APT. Which of the two is a better model
for pricing risky assets and why?

McGraw Hill.
226 Portfolio Management (7th ed.). Pearson Education.
IIT Kharagpur [nptelhrd]. (2012). Lecture 56: Arbitrage Pricing Model III, Capital Market Theory
Portfolio Performance Evaluation [Video]. YouTube. https://
www.youtube.com/watch?v=q_dsbXukVFs
IIT Kharagpur [nptelhrd]. (2012). Mod-01 Lec-23 Capital Market Theory - I
[Video]. YouTube. https://www.youtube.com/watch?v=yI8QdVv2coE
IIT Kharagpur [nptelhrd]. (2012). Mod-01 Lec-24 Capital Market Theory - II
[Video]. YouTube. https://www.youtube.com/watch?v=uxvgUEMcdpU
IIT Kharagpur [nptelhrd]. (2012). Mod-01 Lec-25 Arbitrage Pricing Theory
[Video]. YouTube. https://www.youtube.com/watch?v=MZutAaDgpxA
Chand & Sons.
Singh, J. P., [IIT Roorkee]. (2021). Lecture 51: Capital Asset Pricing Model
I [Video]. YouTube. https://www.youtube.com/watch?v=OiUB9QcFsBA
Singh, J. P., [IIT Roorkee]. (2021). Lecture 53: Capital Asset Pricing Model
III [Video]. YouTube. https://www.youtube.com/watch?v=HTYtINuiDsc
Singh, J. P., [IIT Roorkee]. (2021). Lecture 54: Arbitrage Pricing Model I
[Video]. YouTube. https://www.youtube.com/watch?v=tdiYVNBW2Go
Singh, J. P., [IIT Roorkee]. (2021). Lecture 55: Arbitrage Pricing Model II
[Video]. YouTube. https://www.youtube.com/watch?v=iU867qE1TPA
Singh, J. P., [IIT Roorkee]. (2021).). Lecture 52: Capital Asset Pricing Model
II [Video]. YouTube. https://www.youtube.com/watch?v=9rOPktaVZOE
227
UNIT 13 PORTFOLIO REVISION
Objectives
After reading the unit you should be able to:
x understand need for Portfolio Revision;
x contrast ‘active’ and ‘passive’ portfolio revision strategies;
x highlight portfolio revision practices and the constraints in portfolio
revision;
x discuss and illustrate formula plans for portfolio revision.
Structure
13.1 Introduction
13.2 Need for portfolio revision strategies
13.3 Portfolio revision practices
13.4 Techniques of Portfolio Revision
13.5 Rupee cost and share averaging
13.6 Summary
13.7 Key words
13.8 Self assessment questions
13.1 INTRODUCTION
Most investors are comfortable with buying securities but spend little effort
in revising portfolio or selling stocks. In that process they lose opportunities
to earn good return. In the entire process of portfolio management, portfolio
revision is as important as portfolio analysis and selection. Keeping in mind
the risk-return objective, an investor selects a mix of securities from the given
investment universe. In a dynamic world of investment, it is only natural that
the portfolio may not perform as desired or opportunities might arise turning
the desired into less than desired. Further, some of the risk and return
estimation might change over a period of time. In every such situation, a
portfolio revision is warranted. Portfolio revision involves changing the
existing mix of securities. The objective of portfolio revision is similar to the
objective of portfolio selection i.e., maximizing the return for a given level
of risk or minimizing the risk for a given level of return. The process of
portfolio revision is also similar to the process of portfolio selection. This is
particularly true where active portfolio revision strategy is followed. It calls
for reallocation of funds between bond and stock market through economic
analysis, reallocation of funds among different industries through industry
228
analysis and finally selling and buying of stocks within the industry through Portfolio Revision
company analysis. Where passive portfolio revision strategy is followed, use
of mechanical formula plans may be made. What are these formula plans? We
shall discuss these and other aspects of portfolio revision in this Unit. Let us
begin by highlighting the need for portfolio revision.
13.2 NEED FOR PORTFOLIO REVISION

No plan can be perfect to the extent that it would not need revision sooner or
later. Investment Plans are certainly not. In the context of portfolio
management the need for revision is even more because the financial markets
are continually changing.
Thus the need for portfolio revision might simply arise because market
witnessed some significant changes since the creation of the portfolio. Further,
the need for portfolio revision may arise because of some investor-related
factors such as (i) availability of additional wealth, (ii) change in the risk
attitude and the utility function of the investor, (iii) change in the investment
goals of the investors and (iv) the need to liquidate a part of the portfolio to
provide funds for some alternative uses. The other valid reasons for portfolio
revision such as short-term price fluctuations in the market do also exist.
There are thus numerous factors, which may be broadly called market related
and investor related.
13.3 PORTFOLIO REVISION STRATEGIES

Broadly speaking investors may, depending on their investment objectives
skill and resources, follow ‘active’ or ‘passive’ strategies for portfolio revision.
Active strategy of portfolio revision involves a process similar to portfolio
analysis and selection, which is based on an analysis of fundamental factors
covering economy, industries and companies as well as technical facto As
against this, under passive strategy some kind of formula plans are followed
for revision.
Active revision strategy seeks ‘beating the market by anticipating’ or reacting
to the perceived events or information. Passive revision strategy, on the other
hand, seeks‘performing as the market’. The followers of active revision
strategy are found among believers in the “market inefficiency” whereas
passive revision strategy is the choice of believers in the ‘market efficiency’.
However, some of the formula strategies are on the premise of market
inefficiency. The frequency of trading transactions, as is obvious, will be more
under active revision strategy than under passive revision strategy and so
will be the time, money and resources required for implementing active
revision strategy than for passive revision strategy. In other words, active
and passive revision strategies differ in terms of purpose, process and cost
involved. The choice between the two strategies is certainly not very straight
forward. One has to compare relevant costs and benefits. On the face of it,
active revision strategy might appear quite appealing but in actual practice,
there exist a number of constraints in undertaking portfolio revision itself.
229
Activity 1
a) Define Portfolio Revision.
............................................................................................................
............................................................................................................
............................................................................................................
b) Name two broad sets of factors which may motivate portfolio revision.
............................................................................................................
............................................................................................................
............................................................................................................
c) Distinguish ‘active’ and ‘passive’ strategies of portfolio revision.
............................................................................................................
............................................................................................................
............................................................................................................
13.4 PORTFOLIO REVISION PRACTICES

Investors follow both active and passive portfolio revision strategies. Studies
about portfolio revision strategies show that the efficient market hypothesis
is slowly but continuously gaining and investors revise their portfolio much
less often than they were doing previously because of their rising faith in
market efficiency. Institutional investors on the other hand have shown definite
tendency in the recent past for active revision of their portfolios and most
often to correct their past mistakes. In a volatile market, many funds feel that
without such revision, it would be difficult to show better performance. This
is said to be motivated by their desire to achieve superior performance by
frequent trading to take advantage of their supposedly superior investment
skills.
CONSTRAINTS IN PORTFOLIO REVISION
A look into the portfolio revision practices as discussed above highlight that
there are number of constraints in portfolio revision, in general, and active
portfolio revision, in particular. Let us indicate some common constraints in
portfolio revision as follows:
Transaction Cost: As you know buying and selling of securities involve
transaction cost including brokers’ fee. Frequent buying and selling for
portfolio revision may push up transaction costs beyond gainful limits.
Taxes: In most of the countries, capital gains are taxed at concessional rates.
But for any income to qualify as capital gains, it should be earned after lapse
of a certain period. To qualify such concessional rate of 10% tax, investors
today need to wait for one year after the purchase. The minimum period
230
required to qualify for long-term capital gain is one year for financial assets. Portfolio Revision
Frequent selling for portfolio revision may mean foregoing capital gains tax
concession. Higher the tax differential (between rates of tax for income and
capital gains), higher the constraint. Even for tax switches, which means that
one stock is sold to establish a tax loss and a comparable security is purchased
to replace it in the investor’s portfolio, one must wait for a minimum period
after selling a stock and before repurchasing it, to be able to declare the gain
or loss. If the stock is repurchased before the minimum fixed period, it is
considered a wash sale, and no gain or loss can be claimed for tax purpose.
Statutory Stipulations: In many countries including India, statutory
stipulations have been made to the percentage of investible funds that can be
invested by investment companies/mutual funds in the shares/debentures of a
company or industry. In such a situation, the initiative to revise portfolio is
most likely to get stifled under the burden of various stipulations. Government
owned investment companies and mutual funds are quite often called upon to
support sagging markets (albeit counters) or cool down heated markets, which
puts limit on the active portfolio revision by these companies.
No Single Formula: Portfolio revision is no exact science. Even today there
does not exist clear cut answer to the overall question of whether, when and
how to revise a portfolio. The entire process is fairly cumbersome and time-
consuming. The investment literature does provide some formula plans, which
we shall discuss in the following section, but they have their own assumptions
and limitations.
Activity 2
List out three constraints in portfolio revision.
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
………………………………………………………………………………
13.4 TECHNIQUES OF PORTFOLIO REVISION

FORMULA PLANS
As noticed above, the problem of portfolio revision essentially boils down to
timing the buying and selling the securities. Ideally, investors should buy
when prices are low, and then sell these securities when their prices are high.
But as stock prices fluctuate, the natural tendencies of investors often cause
them to react in a way opposite to one that would enable them to benefit from
these fluctuations. Investors are hesitant to buy when prices are low for fear
that prices will fall further lower, or for fear that prices won’t move upward
again. When pries are high, investors are hesitant to sell because they feel
that prices may rise further and they may realize larger profits. It requires
skill and discipline to buy when stock prices are low and pessimism abounds
231
Portfolio Management and to sell when stock prices are high and optimism prevails. Mechanical
portfolio revision techniques have been developed to ease the problem of
whether and when to revise to achieve the benefits of buying stocks when
prices are low and selling stocks when prices are high. These techniques are
referred to as formula plans. There are three popular formula plans namely,
Constant-Dollar-Value Plan, Constant Ratio Plan and Variable Ratio Plan.
Before discussing each one of these, let us understand the basic assumptions
and ground rules of formula plans.
Basic Assumptions and Ground Rules
The formula plans are based on the following assumptions:
l. The stock prices move up and down in cycles.
2. The stock prices and the high grade bond prices move in the opposite
directions.
3. The investors cannot or are not inclined to forecast direction of the next
fluctuation in stock prices which may be due to lack of skill and resources
or their belief in market efficiency or both.
The use of formula plans calls for the investor to divide his investment funds
into two portfolios, one aggressive and the other conservative or defensive.
The aggressive portfolio usually consists of stocks while conservative portfolio
consists of bonds.
The formula plans specify pre-designated rules for the transfer of funds from the
aggressive into the conservative and vice-versa such that it automatically causes
the investor to sell stocks when their prices are rising and buy stocks when their
prices are falling. Let us now discuss, one by one, the three formula plans.
Constant-Dollar-Value Plan
The Plan (CDVP) asserts that the dollar value (or Rupee Value in Indian
Context) of the stock portion of the portfolio will remain constant. This, in
operational terms, would mean that as the value of the stocks rises, the investor
must automatically sell some of the shares to keep the value of her/his
aggressive portfolio constant. If, on the other hand, the prices of the stocks
fall, the investor must buy additional stocks to keep the value of the aggressive
portfolio constant. By specifying that the aggressive portfolio will remain
constant in dollar value, the plan implies that the remainder of the total fund
will be invested in the conservative fund. In order to implement this plan, an
important question to answer is what will be the action points? Or, in other
words, when will the investor make the transfer called for to keep the dollar
value of the aggressive portfolio constant? Will it be made with every change
in the prices of the stocks comprising the aggressive portfolio? Or, will it be
set according to pre- specified periods of time or percentage change in some
economic or market index or percentage change in the value of the aggressive
portfolio?
The investor must choose pre-determined action points, also called revaluation
232 points, very carefully. The action points can have significant effect on the
returns of the investor. Action points placed at every change or too close Portfolio Revision
would cause excessive transaction costs that reduce return and the action points
placed too far apart may cause the loss of opportunity to profit from
fluctuations that take place between them. Let us take an example to clarify
the working of constant-dollar-value-plan.
Assume an investor has ` 20,000 and s/he divides the investments in two
equal parts of ` 10,000 each. The first part was invested in bonds and the
second one was invested in equity shares. She watches price movements of
stocks and bonds regularly and decides to sell the shares if the equity portfolio
wealth appreciated more than 20% of initial investment of ` 10,000 (i.e.
` 12,000) and invest the sale proceeds in bonds. Similarly, if the equity
portfolio depreciates by 20% of initial wealth of ` 10,000 (i.e. ` 8,000), she
will transfer ` 2,000 from bonds (by selling bonds) to equity and by buying
equity so that the equity part will be brought back to ` 10,000. In other words,
the action point is when the equity portfolio appreciates or depreciates by
20%. In Table 13.1, for an assumed stock price, we have illustrated the portfolio
revision strategy. Note all formula plans will offer a desired result over a
longer period of time.
Table13.1: Example of a Constant-Dollar-Value Formula Plan
Constant-Dollar-ValueFormula
1 2 3 4 5 6 7
Stock Price Value of Value of Value of Total Action Total No.
Index Buy-and- Conservative Aggressive value Points & of shares
hold Portfolio Portfolio (Col.3 + Actions in Formula
Strategy() (Col.5 - (Col.7 x Col.4) () Plan
(800 shares Col.4)() Col.I) ()
x col.l) ()
25 20,000 10,000 10,000 20,000 400
22 17,600 10,000 8,800 18,800 400
20 16,000 10,000 8,000 18,000 400
20 16,000 8,000 10,000 18,000 Buy100 500
shares at
`20*
22 17,600 8,000 11,000 19,000 500
24 19,200 8,000 12,000 20,000 500
24 19,200 10,000 10,000 20,000 Sell 83.3
shares at 416.7
` 24
26 20,800 10,000 10,830 20,830 416.7
28.8 23,040 10,000 12,000 22,000 416.7
28.8 23,080 12,000 10,000 22,000 Sell 69.5
shares at 347.2
` 28.8
25 20,000 12,000 87,00 20,700 347.2
* To restore the stock portfolio to `10,000, `2,000 is transferred from the

conservative’ portfolio and used to purchase 100 shares at ` 20 per share. 233
Portfolio Management In our example, an investor with ` 20,000 for investment decides that the
constant dollar (Rupee) value of her aggressive portfolio will be ` 10,000.
The balance of ` 10,000 will make-up her conservative portfolio at the
beginning. She purchases 400 shares selling at ` 25 per share. She also
determines that she will take action to transfer funds from aggressive portfolio
to conservative portfolio or vice-versa each time the value of her/his aggressive
portfolio reaches 20 per cent above or below the constant value of `10,000.
Table 13.1 shows the positions and actions of the investor during the complete
cycle of the price fluctuations of stocks comprising the portfolio. Although
the example refers to the investment in one stock, the concepts are identical
for a portfolio of stocks, as the value change will be for the total portfolio. In
this example, we have used fractional shares and have ignored transaction
costs to simply the example. In order to highlight the revaluation actions of
our investor, we have shown them ‘boxed’ in table 13.1. The value of the
buy-and-hold strategy is shown in column (2) to enable comparison with the
total value of our investors’ portfolio [column (5)] as per constant-dollar-
value plan of portfolio revision. Notice the revaluation actions (represented
by boxed areas in Table 13.1) taken when the price fluctuated to ` 20, 24, and
28.8, since the value of the aggressive fund become 20 per cent greater or
less than the constant value of ` 10,000. Notice also that the investor using
the constant-dollar-value formula plan has increased the total value of his
fund to ` 20,700 after the complete cycle whilethe buy-and-hold strategy
yielded only ` 20,000. Let us now illustrate anotherformulaplan, namely,
constant-ratio-plan.
Constant-Ratio-Plan
The constant-ratio plan specifies that the value of the aggressive portfolio to
the valueof the conservative portfolio will be held constant at the pre-
determined ratio. This plan automatically forces the investor to sell stocks as
their prices rise, in order to keep the ratio of the value of their aggressive
portfolio to the value of the conservative portfolio constant.
Table 13.2: Example of Constant-Ratio Formula Plan
Constant-Dollar-ValueFormula
1 2 3 4 5 6 7
Stock Price Value of Value of Value of Total Action Total No.
Index Buy-and- Conservative Aggressive value Points & of shares
hold Portfolio Portfolio (Col.3 + Actions in Formula
Strategy() (Col.5 - (Col.7 x Col.4) () Plan
(800 shares Col.4)() Col.I) ()
x col.l) ()
25 20,000 10,000 10,000 20,000 1.00 400
23 18,400 10,000 9,200 19,200 0.92 400
22.5 18,000 10,000 9,000 19,000 0.90 400
22.5 16,200 9,500 9,500 19,000 1.00 422.2
Buy22.2
at Rs225*
20.25 16,200 9,500 8,540 18,040 0.90 422.2
20.25 16,000 9,020 9,020 18,040 1.00 445.9
Buy 23.7
234 at 20.25
Portfolio Revision
20 17,920 9,020 8,910 17,930 0.99 445.9
22.4 17,920 9,020 9,920 18,940 1.10 445.9
22.4 19,920 9,470 9,470 18,940 1.00 425.8
Sell 20.1
at 22.4
24.6 23,080 9,470 10,430 19,900 1.10 425.8
* To restore the ratio from. 90 to 1.00, total value of the fund,19,000, is simply
split in two equal segments of 9,500, and 9500/9,500=1.00. The 500
transferred from the conservative portfolio will buy 22.2 Shares at the
prevailing price of 22.50.
Likewise, the investor is forced to transfer funds from conservative portfolio
to aggressive portfolio as the price of stocks fall. We may clarify the operation
of this plan with the help of an example. For the sake of our example, the
starting point and other information are the same as in the previous example.
The desired ratio is 1:1. The initial fund of 20,000 is thus divided into equal
portfolios of 10,000 each. The action points are pre-determined at ± .10 from
the desired ratio of 1.00. Table 13.2 shows, in boxes, the actions taken by our
investor to readjust the value of the two portfolio store obtain the desired
ratio.
You may notice that the constant-ratio plan calls for more transactions than
the constant -dollar-value plan did, but the actions triggered by this plan are
less aggressive. This plan yielded an increase in total value at the end of the
cycle compared with the total value yielded under constant-dollar-value plan.
It did, however,out perform the buy-and-hold strategy. Let us now explain
and illustrate variable-ratio plan.
Variable-RatioPlan
Variable-ratio plan is a more flexible variation of constant ratio plan.Under
the variable ratio plan, it is provided that if the value of aggressive portfolio
changes by certain percentage or more,the initial ratio between the aggressive
portfolio and conservative portfolio will be allowed to change as per the pre-
determined schedule. Some variations of this plan provide for the ratios to
vary according to economic or market in dices rather than the value of the
aggressive portfolio. Still others use moving averages of indicators. In order
to illustrate the working of variable ratio plan let us continue with the previous
example with the following modifications:
Thevariable-ratio plan states that if the value of the aggressive portfolio rises
by 20 percent or more from the present price of 25, the appropriate ratio of
the aggressive portfolio will be 3:7 instead of the initial ratio of 1:1 Likewise,
if the value of the aggressive portfolio decreases by20 percent or more from
the present price of 25, the appropriate percentage of aggressive portfolio to
conservative portfolio will be 7:3. Table 13.3 presents, in boxes, the actions
taken by our invest or to readjust the value of the aggressive portfolio as per
variable-ratio plan.
235
Portfolio Management Table 13.3: Example of Variable-Ratio Formula Plan
1 2 3 4 5 6 7 8
Stock Value of Value of Value of Total value of Revaluation Total
Price Buy- and- Conservative Aggressive Value Stock as Action No.of
Index hold Portfolio Portfolio (Col.3 + of Total Shares
Strategy() (Col.5- (Col.8 x Col.4) () Fund in
(800 shares Col.4) () Col.l) () (Col.4 + Agressive
x coal) () Col,5) Portfolio
25 20,000. 10,000 10,000 20,000 50% 400
22 17,600 10,000 8,800 18,800 47% 400
20 16,000 10,000 8,000 18,000 44.5% 400
20 16,000 5,400 12,600 18,000 70% Buy 230 630

shares
at 20
22 17,600 5,400 13,860 19,260 72% 630
25 20,000 5,400 15,760 21,160 74.5% 630
25 20,000 10,580 10,580 21160 50% Sell 207 423

shares
at 25
26 20,800 10,580 11,000 20,580 53% 423
28.8 23,040 10,580 12,180 22,760 54% 423
25 20,000 10,580 10,580 21,160 50% 423
You may notice that the increase in the total value of the portfolio after the
complete cycle under this plan is 1,160, which is greater than the increase
registered under the other two formula plans. The revaluation actions/
transactions undertaken are also fewer under this plan compared to other two
plans. Variable ratio plan may thus be more profitable compared to constant-
dollar-value plan and the constant-ratio plan.
But, as is obvious, variable ratio plan demands more forecasting than the
other formula plans. You must have observed, the variable ratio plan requires
forecasting of the range of fluctuations both above and below the initial price
(or say median price) to establish the varying ratios at different levels of
portfolio values. Beyond a point, it might become questionable as to whether
the variable ratio plan is less complicated than the extensive analysis and
forecasting that it was supposed to replace.
Limitations
Indeed, none of the formula plans are a royal road to riches, First, as an effort
to provide mechanical rules for portfolio revision, they make no provision
for what securities should be selected for investment. Second formula plans
by their nature are in flexibility makes it difficult to know if and when to
adjust the plan to new conditions emerging in the investment environment.
Finally, in the absence of much faith in the market efficiency, particularly in
the development stock markets, there may not be many followers of formula
plans for portfolio revision
236
Activity2 Portfolio Revision
a) What is the total value of the portfolios at the end of the complete cycle
under Constant. Dollar Value Plan, Constant Ratio Planand Variable Ratio
Plan in the examples given above.
.............................................................................................................
.............................................................................................................
.............................................................................................................
b) Comment on the differences, if any?
.............................................................................................................
.............................................................................................................
.............................................................................................................
13.5 RUPEE COST AND SHARE AVERAGING

In the formula plans discussed above, investors have to create two portfolios
and switch the investment from one to another depending the market condition.
An alternative to this approach is investing only in stocks and building a portfolio
over a period of time while reducing the cost of acquisition. Often investors get
into the problem of bad investment by betting the entire wealth on stocks. Such
mistakes can be avoided by investing regularly over a period of time and thus
getting an average price of the market. Since stocks have always the tendency
of moving upward and downward, it would be difficult to exactly buy at low
and sell at top. These averaging methods allow the investors to participate in
both bull and bear markets. They are discussed below:
Dollar (orRupee) Cost Averaging
Under this method, an investor will invest a constant amount every period
(saymonthly) in single or group of stocks or invest in index funds. In that
process, if the stock price is low, the investor would be in a position to buy
more stocks (or more units in the case of mutual funds investments) and if the
prices are high, then the investor will purchase less number of stocks or units.
Since the amount invested is same irrespective of the market conditions, this
technique is referred to as Dollar or Rupee cost averaging. Over a period of
time (after couple of bull and bear markets), you can expect the average cost
of holding per share will be considerably less than the current market price.
Note one has to wait for a minimum period to see the impact of such plans.
ShareAveraging
Under this method, the investor will buy the same quantity of stock every
period (say month) irrespective of the market price. That is when the market
is bullish, the investor will invest more money and when the market is bearish,
she or he will investless money. In that process, it automatically allows the
investors to save more in bonds when the market is not doing well and invest
more in stocks when the marketisdoing well. 237
Portfolio Management The following Tables (13.4 and 13.5) illustrates how these two plans work
using X Industries as an example. We are using quarterly prices of last 5
years to show the workings.
Table 13.4 Rupee Cost Averaging Plan
Month Closing No of Wealth as Net Gain Purchased Cumulative

Price Stocks Invest- on date
ment
31-Dec-2017 109.00 4.59 4.59 500.00 500 0.00
31-Mar-2018 128.38 3.89 8.48 1088.90 1000 88.90
30-Jun-2018 185.88 2.69 11.17 2076.61 1500 576.61
30-Sep-2018 180.13 2.78 13.95 2512.37 2000 512.37
31-Dec-2018 165.50 3.02 16.97 2808.32 2500 308.32
31-Mar-2019 176.90 2.83 19.80 3501.76 3000 501.76
30-Jun-2019 143.30 3.49 23.28 3336.64 3500 -163.36
30-Sep-2019 118.80 4.21 27.49 3266.18 4000 -733.82
31-Dec-2019 119.80 4.17 31.67 3793.67 4500 -706.33
31-Mar-2020 130.40 3.83 35.50 4629.34 5000 -370.66
30-Jun-2020 176.70 2.83 38.33 6773.03 5500 1273.03
30-Sep-2020 236.50 2.11 40.44 9565.21 6000 3565.21
30-Dec-2020 233.70 2.14 42.58 9951.96 6500 3451.96
31-Mar-2021 314.50 1.59 44.17 13892.78 7000 6892.78
30-Jun-2021 340.90 1.47 45.64 15558.98 7500 8058.98
29-Sep-2021 342.60 1.46 47.10 16136.57 8000 8136.57
29-Dec-2021 339.00 1.47 48.58 16467.01 8500 7967.0
10-Mar-2022 390.90 1.28 49.85 19488.06 9000 10488.06
9-Jun-2022 369.50 1.35 51.21 18921.18 9500 9421.18
28-Sep-2022 265.85 1.88 53.09 14113.52 10000 4113.52
31-Dec-2022 305.15 1.64 54.73 16699.89 10500 6199.89
The above Table was prepared based on the assumption that an investor invests
500 (you can add more zeroes to make the purchases realistic) every quarter
irrespective of the price. Column 2 shows the market price at the time of
purchase. Column 3 shows the number of stocks that can be purchased with
500. Column 4 gives the cumulative number of shares and column 5 gives the
value of such cumulative stocks on that date (if the investor sells, this much
amount will be available). Column 6 shows the amount invested in such plans
238
and the last column shows the difference between the wealth and investments Portfolio Revision
as on 31.12.2022. At the end of five years, for an investment of 10,500, the
investor could have purchased 54.73 stocks whose wealth on that day is
16,700. It gives a net appreciation of 6,200. The average cost per share works
out to 191.86 against the market price of 305 as on 31.12.2022. The investor
incurring loss in this stock is unlikely given the difference between the average
cost of acquisition and current market price. The investment offers an average
return of 4.4% per quarter, which will move upward once the stock price
moves forward. To succeed this plan, one has to wait more time and increase
the frequency of investment, say from quarterly to monthly.
If an investor followed the share average plan, she would have got the
following returns.
Table 13.5 Share Average Plan
Month Closing No of Wealth as Net Gain Purchased Cumulative

Price Stocks Invest- on date
ment
31-Dec-2017 109.00 2.00 2.00 218.00 218.00 0.00
31-Mar-2018 128.38 2.00 4.00 513.52 474.76 38.76
30-Jun-2018 185.88 2.00 6.00 1115.28 846.52 268.76

30-Sep-2018 180.13 2.00 8.00 1441.04 1206.78 234.26
31-Dec-2018 165.50 2.00 10.00 1655.00 1537.78 117.22

31-Mar-2019 176.90 2.00 12.00 2122.80 1891.58 231.22
30-Jun-2019 143.30 2.00 14.00 2006.20 2178.18 -171.98
30-Sep-2019 118.80 2.00 16.00 1900.80 2415.78 -514.98

31-Dec-2019 119.80 2.00 18.00 2156.40 2655.38 -498.98
31-Mar-2020 130.40 2.00 20.00 2608.00 2916.18 -308.18

30-Jun-2020 176.70 2.00 22.00 3887.40 3269.58 617.82
30-Sep-2020 236.50 2.00 24.00 5676.00 3742.58 1933.42
30-Dec-2020 233.70 2.00 26.00 6076.20 4209.98 1866.22

31-Mar-2021 314.50 2.00 28.00 8806.00 4838.98 3967.02
30-Jun-2021 340.90 2.00 30.00 10227.00 5520.78 4706.22
29-Sep-2021 342:60 2.00 32.00 10963.20 6205.98 4757.22
29-Dec-2021 339.00 2.00 34.00 11526.00 6883.98 4642.02

30-Mar-2022 390.90 2.00 36.00 14072.40 7665.78 6406.62
9-Jun-2022 369.50 2.00 38.00 14041.00 8404.78 5636.22
28-Sep-2022 265.85 2.00 40.00 10634.00 8936.48 1697.52

31-Dec-2022 305.15 2.00 42.00 12816.30 9546.78 3269.52
239
Portfolio Management Under this plan, the investor purchases 2 shares per quarter and in that process,
s/he would have purchased 42 stock by investing an amount of 9546.78. The
average cost of acquisition is 227.30 against the current market rate of 305.15
as on 31.12.2022. This investment plan offers a return of 3.6% per quarter.
On comparison, when the market prices are volatile, the constant dollar or
Rupee cost averaging is better than share averaging. On the other hand, if the
market is on the uptrend for a long period of time, share averaging will yield
better returns. Further share averaging may demand more investment if the
prices have gone up too high. In dollar cost averaging, the amount is held
constant and one can plan for such periodic investment in portfolio of stocks.
Depending on the investors’ willingness to invest money and availability of
money and also their forecast on the future, they can choose one of the two
methods.
13.6 SUMMARY
In this unit, we have noticed that in the entire process of portfolio management,
portfolio revision, which involves changing the existing mix of securities, is
as important as portfolioanalysis and selection. The portfolio revision
strategies adopted by investors can be broadlyclassified as ‘active’; and
‘passive’; revision strategies. This Unit also points out that whileboth ‘active
and ‘passive’ revision strategies are followed by believers of market efficiency
orthose, who lack portfolio analysis and selection skills and resources. Major
constraints,which come in the way of portfolio revision, are transaction costs,
taxes, statutorystipulations and lack of ideal formula. This unit also discusses
and illustrates three formulaplans of portfolio revision, namely, constant-
dollar-value plan, constant-ratio plan, andvariable-ratio plan. Before closing
the discussion about formula plans, it was also noted that these formula plans
are not a royal road to riches. They have their own limitations. The choice of
portfolio revision strategy or plan is thus no simple question. The choice will
involvecost and benefit analysis.
13.7 KEY WORDS

Constant-Dollar-Value Plan : The Plan (CDVP) asserts that the dollar
value (or Rupee Value in Indian Context) of
the stock portion of the portfolio will remain
constant.
Dollar(orRupee) Cost : Under this method, an investor will invest
Averaging a constant amount every period (saymonthly)
in single or group of stocks or invest in index
funds.
Portfolio revision : It involves changing the existing mix of
securities.
240
Portfolio Revision
1. ‘In the Indian Context, buy-and-hold is a better strategy compare to any
of the portfolio revision strategies’. Comment.
2. Compare and contrast constant-dollar-value plan, constant-ratio plan and
variable- ratio plan. You may use hypothetical data.
4. ‘Formula plans are hardly useful in the Indian Context.’ Comment.
5. ‘Formula plans are good because they aid the investor in overcoming his
emotional involvement with the timing of the purchase and sale of stock.
Comment.
6. Critically evaluate the three formula plans and suggest modification, if
any, to make them useful for investors in Indian Stock market..
7. Why does the need arise for portfolio revision? What are the constraints
in portfolio revision?

McGraw Hill.
IIT Kharagpur [nptelhrd]. (2012). Mod-01 Lec-29 Equity Portfolio
Management Strategies - I [Video]. YouTube. https://www.youtube.com/
watch?v=rW3yM6MCKR4
IIT Kharagpur [nptelhrd]. (2012). Mod-01 Lec-30 Equity Portfolio
Management Strategies - II [Video]. YouTube. https://www.youtube.com/
watch?v=3mX_T4-8dEo
Reilly, F. K., Brown, K. C., Gunasingham, B., Lamba, A., &Elston, F. (2019).
Chand & Sons.
241

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MMPF-004 Valuation of Securities

10.2 NEED FOR PORTFOLIOS

10.3 RISK AND RETURN

Statistical measures of risk

b) Coefficient of Variation (CV)

Expected Rate of Return

10.4 EXPECTED RISK AND RETURN FROM A

Assets Monthly Average Standard Proportion

Mean 0.38% 0.64% -0.25%

Variance 0.0029 0.0133 0.0048

Standard Deviation 5.37% 11.55% 6.93%

H 0.0029 0.0001 0.0011

I 0.0001 0.0133 0.0016

T 0.0011 0.0016 0.0048

I 30% .5 x .3 x .0001 .3 x .3 x .0133 .2 x .3 x .0016

T 20% .5 x .2 x .0011 .3 x .2 x.0016 .2 x .2 x .0048

Figure 10.3: Correlation and Portfolio Risk

Figure 10.4: Risk and Return of Portfolios of H and I

10.6 PORTFOLIO SELECTION

Figure 10.6: Efficient Set of Portfolios

If the above understanding is clear intuitively, we can now proceed to learn

10.8 KEY WORDS

10.8 SELF-ASSESSMENT QUESTIONS

10.9 FURTHER READINGS

11.2 RISK AND INVESTOR PREFERENCE

11.3 GENERATING EFFICIENT FRONTIER

11.4 EFFICIENT SET

The above kind of non-linear minimization problem can be solved by applying

In this context, it would be interesting to know the concepts of ‘corner

Figure 11.2: ACC Return vs. Sensex Return

Portfolio Beta = Weighted average of individual share betas

Portfolio residual variance = Weighted average of individual residual variances

11.6 OTHER PORTFOLIO SELECTION MODELS

11.8 KEY WORDS

11.9 SELF-ASSESSMENT QUESTIONS

11.10 FURTHER READINGS

12.2 RISK-FREE ASSET

Figure 12.1: Efficient Set of Portfolios with Risk-Free Asset

Figure 12.2: Capital Market Line

Risk (Return Volatility)

218 (Price of time) + [(Price of risk) x (Amount of risk)]

In the foregoing discussion we assumed that risk-free rates of lending and

Figure 12.3: Efficient Set of Portfolios with different Risk-free rates

The construction of this efficient set can be explained as follows: If R fL = RfB,

12.4 CAPITAL ASSET PRICING MODEL (CAPM)

12.5 ARBITRAGE PRICING THEORY

12.7 KEY WORDS

12.8 SELF-ASSESSMENT QUESTIONS

12.9 FURTHER READINGS

13.2 NEED FOR PORTFOLIO REVISION

13.3 PORTFOLIO REVISION STRATEGIES

13.4 PORTFOLIO REVISION PRACTICES

13.4 TECHNIQUES OF PORTFOLIO REVISION

25 20,000 12,000 87,00 20,700 347.2

* To restore the stock portfolio to `10,000, `2,000 is transferred from the

25 20,000. 10,000 10,000 20,000 50% 400

22 17,600 10,000 8,800 18,800 47% 400

20 16,000 10,000 8,000 18,000 44.5% 400