Chapter - 5 Risk Analysis and Portfolio Management 48 - 72 PDF

CA FINAL – SFM
RISK, RETURN AND PORTFOLIO THEORY

Analysis of a simple security
Returns
1. Meaning
Return comprises the income, which is in the help of dividends or interest, and the capital
gain (loss). It is expressed in percentage form and it is calculated as follows
D1  P1  D1  P1 
P0 = ke =   –1
1 ke  P0 
Alternatively,
D1
ke = +g
P0
Question 1 [Adapted]
RM Ltd. has been showing a consistent growth in the share price as well as dividends in the
recent past. Such growth rate is about 10% per annum. Price of this share prevailing today is
Rs.140 per share. The company has declared a dividend of ₹ 21 in the current year. You are
required to determine the expected rate of return for the shareholder at present.
Determine the average rate of return based on the following data:
Year Expected Dividend (Rs.) Expected Share Price
(Rs.)
1 20 216
2 22 250
3 24 256
4 25 240
5 30 260
Presently the price of the share is Rs.200.
The rates of returns in past 20 years have been observed as follows:
Year Returns Year Returns
1 16% 11 16%
2 18% 12 12%
3 15% 13 18%
4 16% 14 21%
5 15% 15 15%
6 16% 16 16%
7 21% 17 18%
8 18% 18 21%
9 15% 19 21%
10 12% 20 18%
Determine Average rate of Return over the past 20 years.
Page 48 Compiled by Rahul Malkan(RM)

CA FINAL – SFM
Consider the data given in Question 3 and use probabilities for determining the expected
rate of return.
Question 5 [PM]
A stock costing Rs.120 pays no dividends. The possible prices that the stock might sell for at
the end of the year with the respective probabilities are:
Price Probabilities
115 0.1
120 0.1
125 0.2
130 0.3
135 0.2
140 0.1
Required:
Calculate the expected return.
Mr. A acquires an equity share in RM Ltd. at price of Rs.200 today. He expects the following
over a time span of 5 years ahead:
Year Dividend Price
1 25 190.00
2 30 212.80
3 35 266.00
4 40 252.70
5 50 379.05
You are required to determine the rate of return expected by Mr. A in each of the coming 5
years and also indicate the average rate of return he expects.
Risk Associated with investment

Measurement of risk with respect to, investments is very important. All investments are not
free from risk. Therefore, measuring the degree of risk involved is required before an
investment decision is taken.
Standard Deviation
Standard Deviation is one of the most popular and effective tool for measuring risk.
Standard Deviation is a measure of absolute risk. The deviation in the returns can be
considered as a basic cause of risk. For e.g. - A company distributes constantly same rate of
dividend irrespective of market conditions where as another company distributes dividend
at highly varying rates depending upon the market conditions. Obviously, the investor would
consider the first company as better from the view point of risk involved in investments.
Determine Standard Deviation from the data given in Question 3 (Using simple individual
series)
Compiled By Rahul Malkan(RM) Page 49

CA FINAL – SFM
Determine Standard Deviation of Returns from the data given in Question 3 (Using
Probabilities)
Question 9 [PM] [Nov 2009 – 8 Marks]

A stock costing Rs.120 pays no dividends. The possible prices that the stock might sell for at
the end of the year with the respective probabilities are:
Price Probabilities
115 0.1
120 0.1
125 0.2
130 0.3
135 0.2
140 0.1
Required:
1. Calculate the expected return.
2. Calculate the standard deviation of returns.
Significance and limitations of standard deviation

Standard Deviation is a measure of risk involved in any security. It is a measure of absolute
risk. While comparing the performance of any security with the other, standard deviation
may not always be appropriate basis of analyzing the performance in terms of relative risk.
The following example will clarify the point:
Consider the following cases:
CASE 1:
Particulars Securities
X Y
Rate of Return 15% 15%
Standard Deviation 2% 3%
CASE 2:
X Y
CASE 3:
X Y
CASE 4:

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X Y
Standard Deviation 1.6% 3%
You are required to analyze the above four cases and observe whether standard deviation
will be effective tool for decision on selection of one out of the two securities X and Y.
Measure of relative risk (co-efficient of variation) (cv)

Co-efficient of Variation is a measure of relative risk, because it measures risk in terms of
each percentage of returns.
S tan dard Deviation 
CV = 
Expected Rate of Return Re turns
The relative risk measure i.e., Co-efficient of Variation shall indicate the degree of risk for
each percentage of return.
Calculate Co-efficient of Variation for Case 4 on Question no 10 above.
Covariance & Correlation
Covariance is a measure of how much two random variables change together. If the greater
values of one variable mainly correspond with the greater values of the other variable, and
the same holds for the smaller values, i.e., the variables tend to show similar behavior, the
covariance is positive. In the opposite case, when the greater values of one variable mainly
correspond to the smaller values of the other, i.e., the variables tend to show opposite
behavior, the covariance is negative.
COVxy = ∑xy Where x = Average Value of X and y = Average Value of y

n
Correlation is another way to determine how two variables are related. In addition to telling
you whether variables are positively or inversely related, correlation also tells you the
degree to which the variables tend to move together.
Consider the following data for securities 'X' & Y
Year Returns on Securities
X Y
1 17% 15%
2 18% 19%
3 20% 22%
4 21% 24%
5 19% 19%
6 18% 17%
7 20% 20%

CA FINAL – SFM
8 22% 24%
You are required to determine:
1. Average Rate of Return for the two Securities
2. Standard Deviation of the two Securities
3. Co-efficient of variation for the two Securities
4. Co-variance between the two Securities
5. Correlation between the two Securities
The historical rates of return of two securities over the past ten years are given. Calculate
the covariance and the correlation coefficient of the two securities.
Years 1 2 3 4 5 6 7 8 9 10
Security 1 12 8 7 14 16 15 18 20 16 22
Security 2 20 22 24 18 15 20 24 25 22 20
Concept of CAPM, Alpha () and Beta 
Meaning of Capital Asset Pricing Model (capm)

This model is based on the concept that the expected return on a security is aggregate of
the risk free rate and the premium for the risk.
The Required rate of return will be given by
Re = Rf + (Rm – Rf)β
Equity shares of RM Ltd. have  as 1.2. The average rate of return prevailing in the market is
20% and the risk free interest rate is 10% per annum. You are required to determine the
following:
1. Expected rate of return based on CAPM
Consider the data provided in Question 15. The average rate of return prevailing in the
market is 20% as against the risk free rate of 10%. Therefore, the excess of returns over the
risk free rate will be considered as premium for the risk. Therefore, an investor making an
investment in the stock market will expect a return of 10 + 10 = 20% i.e., risk free rate + the
reward for risk in the form of premium. However, if the investor makes an investment in
equity shares of RM Ltd., the risk in this security is 20% higher than that prevailing in the
market indicated by its  of 1.2 as against the market  of 1.0. Therefore, such investor will
expect a premium of 10 x 1.2 = 12% over and above the risk free rate of 10%. Therefore, the
expected rate of return as per CAPM for RM Ltd.'s share will be 22%.
Question 15 [Nov 08 – 6 Marks]

ABC Ltd. has been maintaining a growth rate of 10 per cent in dividends. The company has
paid dividend @ Rs.3 per share. The rate return on market portfolio is 12 percent and the
risk free rate of return in the market has been observed as 8 percent. The Beta co-efficient
of company's share is 15.
You are required to calculate the expected rate of return on company's shares as per CAPM
model and equilibrium price per share by dividend growth model.

CA FINAL – SFM
Question 16 [May 05 – 6 Marks]

A Company pays a dividend of Rs.2.00 per share with a growth rate of 7%. The risk free rate
is 9% and the market rate of return is 13%. The Company has a beta factor of 1.50.
However, due to a decision of the Finance Manager, beta is likely to increase to 1.75. Find
out the present as well as the likely value of the share after the decision.
Meaning of Alpha ()
Alpha is the excess of returns provided by a security over its expected returns as per CAPM.
If  of a security is positive then it is beneficial to invest in such security.
Risk Free Rate = 7% p.a.
Rate of Return in the Market = 15% p.a.
Average Rate of Return on Security 'X' = 17.69% p.a.
Beta of Security 'X' = 1.2 times
You are required to analyze, the situation using Capital Asset Pricing Model and determine
the alpha for Security 'X' and decide whether it is worth investing in Security 'X'
Equity shares of RM Ltd. are presently quoted at Rs.210. These shares have been regularly
providing an yield of 30% with  as 1.2. The average rate of return prevailing in the market is
20% and the risk free interest rate is 10% per annum. You are required to determine the
following:
1. Expected rate of return based on CAPM
2.  for this security
3. Whether these shares should be acquired at present
Meaning of 
 is a factor that measure risk associated with any security. It indicates the risk involved in
its returns as compared to the risk prevailing in the market.
The Beta of the market (base ) is always equal to 1.00. In Question 15, the  of RM Ltd.
share is 1.20 times which indicates 20% additional risk as compared to the risk level
prevailing in the market. In other words, if the average market returns decline by 2%, the
decline in RM Ltd.'s share will be by 1.2 X 2 = 2.4%. To conclude, we can say that p factor is
the measure of risk involved in returns of a security in relation to the risk involved in the
market.
Calculation of 
Beta can be computed by any of the following methods:
1. Direct Method
2. Co-Variance Method
3. Correlation Method
Calculation of  by Direct Method

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x =
 XM  n.x.m
 M  n.m
2 2
Calculation of  by Co-variance Method

Cov xm
x =
2m
Calculation of  by correlation Method

x
x = Corxm x
m
Given below is information of market rates of returns and data from two companies A and B
Year 2002 Year 2003 Year 2004
Market (%) 12.0 11.0 9.0
Company A (%) 13.0 11.5 9.8
Company B (%) 11.0 10.5 9.5
Required
Determine the beta co-efficient of the shares of company A and Company B
Consider the following data:
Year Rate of Return Rate of Return for X Rate of Return for Y
prevailing in market Company Company
1 16% 15% 14%
2 18% 16% 20%
3 14% 14% 12%
4 16% 15% 16%
5 20% 17% 24%
You are required to calculate the following:
1. Variance and Standard Deviation of market returns
2. Standard Deviation of return for Company X and Company Y
3. Covariance of returns of Company X with market and that of Company Y with market
4. Correlation between returns of Company X and market as well as between returns of
Company Y with market
5.  using direct method
6.  using covariance
7.  using correlation
8. Coefficient of variation for market, Company X and Company Y
9. Interpret the outcome of coefficient of variation
10. Determine expected rate of return for Company X and Company Y using CAPM and
interpret the results. (Assume Risk Free Rate as 10%)
portfolio management
meaning of an investment portfolio

CA FINAL – SFM
An Investment Portfolio is a collection of investments, owned by an individual or

organization. These investments often include stocks, which are investments in individual
businesses; bonds, which are investments in debt that are designed to earn interest; and
mutual funds, which are essentially pools of money from many investors that are invested
by professionals or according to indices.
An Investment Portfolio is a grouping of financial assets such as stocks, bonds and cash
equivalents, as well as their mutual, exchange-traded and closed-fund counterparts.
Portfolios are held directly' by investors and/or managed by financial professionals.
Measuring Portfolio Returns (RP)
RM's Funda # 1:
“Return on Portfolio is the weighted average of returns of individual securities included in

the portfolio where the weights are the proportions of money invested in each security or
the market values of such securities at a particular date.”
Calculate the return on portfolio based on Given information-
Security Value Today Expected Dividend Expected Value
after 1 Year after 1 Year
Rs. Rs. Rs.
A 2,00,000 20,000 3,00,000
B 3,00,000 45,000 3,00,000
C 1,00,000 15,000 1,35,000
D 5,00,000 0 6,00,000
E 2,00,000 40,000 1,80,000
Also determine expected rate of return for each security and reconcile the rate of return on
portfolio.
Measuring Overall Portfolio Risk (p)
RM’s Funda  2 :
“The first Principle here means to treat a Portfolio as an individual security, for determining
its risk and return.”
RM’s Funda  3 :

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“Using the First Principle, for determining risk and returns of a portfolio should give same
results as obtained by determining such risk and returns as weighted average of risk and
returns of individual securities included in the portfolio."
Consider the following data regarding two securities X and Y :
Market Conditions Probability R(x) R(y)
Very Good 0.25 22 16
Good 0.25 18 14
Average 0.25 14 12
Bad 0.25 10 10
You are required to determine the following:
1. Expected rate of return for Security X and Y
2. Standard Deviation of returns for both the Securities
3. Correlation between returns of X and Y
4. Average return on portfolio or expected return on portfolio if the investor has
invested 75% of this total money in Security X and the remaining in Security Y.
5. Standard Deviation of the portfolio by 1st Principle Method
6. Standard Deviation of the portfolio by Direct Method
Questions 23 [Adapted]
Use the data in Question 32 and determine the portfolio risk in terms of standard deviation
for the following situations:
% Investment
Situation In X In Y
1 50 50
2 30 70
3 20 80
4 70 30
5 80 20
Also determine the Co-efficient of Variation in the portfolio returns for each of the above
situations and suggest which combination will be the best based on Co-efficient of Variation.
Questions 24 (For Your Practice)

Market Conditions Rx Ry Probability
Very Good 25% 30% 0.2
Good 22% 24% 0.3
Average 18% 16% 0.3
Bad 16% 15% 0.1
Very Bad 14% 5% 0.1
Compute the following:
1. Average rate of return for x and y based on market conditions (Expected Rate of
Return)
2. Standard Deviation of returns for both the Companies
3. Covariance of returns of x and y
4. Correlation between returns of x and y

CA FINAL – SFM
5. Compute the return on portfolio if the proportion of investment in x and y is 0.5 each
6. Compute the overall risk by first principle method
7. Compute the overall portfolio risk by direct method (Using Formula)
Questions 25 [PM]
Mr. A is interested to invest RS 1,00,000 in the securities market. He selected two securities
B and D for this purpose. The risk return profile of these securities are as follows
Security Risk (σ) Expected Return (ER)
B 10% 12%
D 18% 20%
Co-efficient of correlation between B and D is 0.15.
You are required to calculate the portfolio return of the following portfolios of B and D to
be considered by A for his investment.
(i) 100 percent investment in B only;
(ii) 50 percent of the fund in Band the rest 50 percent in D;
(iii) 75 percent of the fund in B and the rest 25 percent in D; and
(iv) 100 percent investment in D only.
Also indicate that which portfolio is best for him from risk as well as return point of view?
Questions 26 [PM]
Consider the following information on two stocks, A and B:
Year Return on A (%) Return on B (%)

2006 10 12
2007 16 18
(i) The expected return on a portfolio containing A and B in the proportion of
40% and 60% respectively.
(ii) The Standard Deviation of return from each of the two stocks.
(iii) The covariance of returns from the two stocks.
(iv) Correlation coefficient between the returns of the two stocks.
(v) The risk of a portfolio containing A and B in the proportion of 40% and 60%.
Questions 27 [PM]
Consider the following information on two stocks X and Y:
Year Return on X(%) Return on X (%)
2008 12 10
2009 18 16
(i) The expected return on a portfolio containing X and Y in the proportion of 60% and
40% respectively..
(ii) The standard deviation of return from each of the two stocks.
(iii) The covariance of returns from the two stocks.
(iv) Correlation co-efficient between the returns of the two stocks.
(iv) The risk of portfolio containing X and Y in the proportion of 60% and 40%.

CA FINAL – SFM
Measuring Portfolio Beta ( p) and Alpha ()
RM's Funda # 4:
“Portfolio Beta () is the weighted average of Betas () of individual securities included in
the portfolio, where the weights are the proportions of money invested in each security or
the market values of such securities at a particular date."
Market Rate of Return (%)
Conditions Probability Market Company X Company Y
Very Good 0.2 22 30 18
Good 0.2 20 24 16
Average 0.4 16 17 14
Bad 0.1 10 9 12
Very Bad 0.1 6 2 10
Risk Free Rate is 10%. Weight: X = 30% and Y = 70%
Compute for both the companies:
1.  of X and of Y 2. Weighted Average of  of portfolio
3.  of portfolio based on portfolio returns
4. Also determine portfolio 
Systematic and unsystematic risk

All investments are subject to risk. It is generally believed that investors are rewarded for
taking risk. However, some risk is not rewarded. Investors need to control or eliminate risks
for which they are not rewarded from their investment portfolio. Investment risks can be
placed into two broad categories: unsystematic and systematic risks.
Unsystematic risk (also called diversifiable risk) is risk that is specific to a company.
"Diversification can greatly reduce unsystematic risk from a portfolio."
Diversifiable risk (also known as unsystematic risk) represents the portion of an asset's risk
that is associated with random causes that can be eliminated through diversification. It's
attributable to firm-specific events, such as strikes, lawsuit, regulatory actions, and loss of a
key account. Unsystematic risk is due to factors specific to an industry or a company like
labor unions, product category, research and development, pricing, marketing strategy etc.
There is no reward for taking on unneeded unsystematic risk. By diversifying, one can
reduce unsystematic risk. While the non-diversifiable risk (also known as systematic risk) is
the relevant portion of an asset's risk attributable to market factors that affect all firms such
as war, inflation, international incidents, and political events. It cannot be eliminated
through diversification and the combination of a security's non-diversifiable risk and
diversifiable risk is called total risk.
In the other word Systematic risk is due to risk factors that affect the entire market such as
investment policy changes, foreign investment policy, change in taxation clauses, shift in
socio economic parameters, global security threats and measures etc. Systematic risk is
beyond the control of investors and cannot be mitigated to a large extent. In contrast to

CA FINAL – SFM
this, the unsystematic risk can be mitigated through portfolio diversification. It is a risk that
can be avoided and the market does not compensate for taking such risks.
Year Rm Rx Ry
1 15 15 15
2 17 16 18
3 19 17 21
4 21 18 24
5 21 18 24
6 19 17 21
7 17 16 18
8 15 15 15
Calculate the following:
1. Standard Deviation and variance of Market
2. Standard Deviation and variance of Security X and Security Y
3.  of Security X and Security Y
4. Systematic and Unsystematic Risk of Security X and Security Y by the following
approach
a. Variance Approach
b. Standard Deviation Approach
Also show the Characteristic Line for Security X and Security Y
Standard Deviation of X 2.60
Standard Deviation of Y 1.40
Standard Deviation of Market 2.10
Correlation between X and M 0.82
Correlation between Y and M 0.76
Correlation between X and Y , 0.92
1. Variance and Standard Deviation of portfolio if the weight of Sec X & Sec Y is.0.7 and
0.3 respectively
2. Beta of Sec X and Y 3. Portfolio Beta
4. Systematic & Unsystematic of Portfolio using Standard Deviation basis
5. Systematic & Unsystematic of Portfolio using Variance
Beta & Leverages
B Ltd. has raised a capital of Rs.16 crores which includes Debt of Rs.6 crores and the balance
as Equity. The Debt  for this company is 0.18. The amount of Rs.16 crores has been
invested into the following projects:
Project Amount Invested Project 

CA FINAL – SFM
Real Estate Development 8 Crores 1.8

Pharmaceuticals 6 Crores 1.2
Retail Marketing 2 Crores 0.7
You are required to determine the equity p tor the project.
Questions 32 [May 2002 – 4 Marks]

A project had an equity beta of 1.2 and was going to be financed by a combination of 30%
debt and 70% equity. Assuming debt-beta to be zero, calculate the Project beta taking risk-
free-rate of return to be 10% and return on market portfolio at 18%.
Characteristic Line
A Characteristic line exhibits regression relationship between the return on an investment

and the return on market portfolio
Characteristic Line
 = R – E(R)
R =  + E(R)
R =  + Rf + (Rm – Rf)
R – Rf =  + (Rm – Rf)
Let, Rx – Rf = y
Rm – Rf = x
y =  + .x
The rates of return on the security of company Y and market portfolio for 10 periods are
given below.
Period Return from Security Y % Return on Market portfolio %
1 20 22
2 22 20
3 25 18
4 21 16
5 18 20
6 -5 8
7 17 -6
8 19 5
9 -7 6
10 20 11
What is Beta ? What is Alpha ? What is the characteristic line of the security? Draw
characteristic Line.
Beta of N Ltd is 1.4 times. Rate of Return on Market Portfolio = 15%. Risk Free Rate = 10%
p.a. Average Rate of Return observed on security of N Ltd = 22%
You are required to determine Expected Rate of Return as per Capital Asset Pricing Model
and determine the alpha for security of N Ltd. Also show the characteristic line

CA FINAL – SFM
Security Market Line

A Security market line exhibits relationship between expected returns (Calculated on the
basis of CAPM) of investments and their Betas. (By expected return we mean, the total
return an investor should get considering the risk he has undertaken)
To Draw the line, Betas are taken on X-axis and the expected returns on Y - axis
RF 10%. RM 15%. From the following information draw SML
Securities Likely Returns Beta
Shares of A Ltd. 13.00% 0.50
Shares of B Ltd. 14.00% 1.00
Shares of C Ltd. 18.00% 1.50
Shares of D Ltd. 20.00% 2.00
Which share should be undervalued / overvalued?
Capital Market Line

A CML exhibits relationship between expected returns of investors and their standard –
deviations. (By expected we mean, the total return an investor should get considering the
risk he has undertaken). To draw this line SDs are taken on X-axis and the expected returns
on Y – axis.
The following data relate to four different portfolios
Portfolio Expected Rate of Return S.D.of Returns from portfolio
A 16% 6.00
B 14% 7.50
C 12% 3.00
D 15% 9.00
The expected return on Market portfolio is 9.50 % with the standard deviation of 3. The Rf is
5%. Draw CML to comment on each of these portfolios.
Lets Practice -
Questions 37 [Nov 2003 – 10 Marks] [PM]

The rates of return on the security of Company X and market portfolio for 10 periods are
given below:
Period Return of Security Return on Market Portfolio
X (%) (%)

CA FINAL – SFM
1 20 22
2 22 20
3 25 18
4 21 16
5 18 20
6 –5 8
7 17 –6
8 19 5
9 –7 6
10 20 11
1. What is the beta of Security X?
2. What is the characteristic line for security X?

Given below is information of market rates of Returns and Data from two Companies A and
B:
Year 2002 Year 2003 Year 2004
Market (%) 12.0 11.0 9.0
Company A (%) 13.0 11.5 9.8
Company B (%) 11.0 10.5 9.5
Required:
1. Determine the beta co-efficient of the Shares of Company A and Company B.
2. Distinguish between 'Systematic risk' and 'Unsystematic risk'.
Questions 39 [May 06 – 8 Marks] [PM]

The distribution of return of security ‘F’ and the market portfolio ‘P’ given below:
Probability Return %
F P
0.30 30 – 10
0.40 20 20
0.30 0 30
You are required to calculate the expected return of security ‘F’ and the market portfolio ‘P’
the covariance between the market portfolio and security and beta for the security.

Following is the data regarding six securities:
A B C D E F
Return (%) 8 8 12 4 9 8
Risk (Standard deviation) 4 5 12 4 5 6
1. Assuming three will have to be selected, state which ones will be picked
2. Assuming perfect correlation, show whether it is preferable to invest 75% in A and
25% in C or to invest 100% in E.
Questions 41 [May - 04 – 8 Marks] [PM]

Following is the data regarding six securities:
U V W X Y Z

CA FINAL – SFM
Return (%) 10 10 15 5 11 10
Risk (%) (Standard deviation) 5 6 13 5 6 7
Which of three securities will be selected?
Assuming perfect correlation, analyse whether it is preferable to invest 80% in security U
and 20% in security W or to invest 100% in Y.

A study by a Mutual fund has revealed the following data in respect of three securities:
Security SD(%) Correlation with
index, Pm
A 20 0.60
B 18 0.95
C 12 0.75
The standard deviation of market portfolio (BSE Sensex) is observed to be 15%.
1. What is the sensitivity of returns of each stock with respect to the market?
2. What are the covariances among the various stocks?
3. What would be the risk of portfolio consisting of all the three stocks equally?
4. What is the beta of the portfolio consisting of equal investment in each stock?
5. What is the total, systematic and unsystematic risk of the portfolio in (iv) ?

Mr. X owns a portfolio with the following characteristics:
Security A Security B Risk Free
security
Factor 1 0.80 1.50 0
sensitivity
Factor 2 0.60 1.20 0
sensitivity
Expected Return 15% 20% 10%
It is assumed that security returns are generated by a two factor model.
1. If Mr. X has f 1,00,000 to invest and sells short Rs 50,000 of security B and purchases
Rs 1,50,000 of security A what is the sensitivity of Mr. X's portfolio to the two
factors?
2. If Mr. X borrows Rs 1,00,000 at the risk free rate and invests the amount he borrows
along with the original amount of Rs 1,00,000 in security A and B in the same
proportion as described in part (i), what is the sensitivity of the portfolio to the two
factors?
3. What is the expected return premium of factor 2?
Questions 44 [Nov - 07 – 8 Marks] [PM]

The historical rates of return of two securities over the past ten years are given. Calculate
the Co- variance and the Correlation coefficient of the two securities:
Year 1 2 3 4 5 6 7 8 9 10
Security 1 (return per cent) 12 8 7 14 16 15 18 20 16 22
Security 2 (return; per cent) 20 22 24 18 15 20 24 25 22 20
Questions 45 [Nov - 09 – 10 Marks] [PM]

CA FINAL – SFM
An investor holds two stocks A and B. An analyst prepared ex-ante probability distribution
for the possible economic scenarios and the conditional returns for 2 stocks and the market
index as shown below:
Conditional Returns (%)
Economic Scenario Probability A B Market
Growth 0.40 25 20 18
Stagnation 0.30 10 15 13
Recession 0.30 -5 -8 -3
The risk free rate during the next year is expected to be around 11%. Determine whether
the investor should liquidate his holdings in stock A and B or on the contrary make fresh
investments in them. CAPM assumptions are holding true.

An investor is holding 1,000 shares of Fat lass Company. Presently the rate of dividend being
paid by the company is Rs.2 per share and the share is being sold at Rs.25 per share in the
market. However, several factors are likely to change during the course of the year as
indicated below:
Existing Revised
Risk free rate 12% 10%
Market risk premium 6% 4%
Beta value 1.4 1.25
Expected growth rate 5% 9%
In view of the above factors whether the investor should buy, hold or sell the shares? And
why?
Questions 47 [PM]
Market Conditions Rm Rx Probability
Good 20% 26% 0.3
Average 18% 20% 0.5
Bad 15% 12% 0.2
Risk free rate of return is 10%
1. Standard Deviation of returns of market and Security X
3.  of security X and expected returns as per CAPM
Mr. V has Rs.5,00,000 invested in a Companies X, Y and Z in the ratio of 3:3:4. The p of
equity shares of X, Y and Z are 1.2,1.6 and 1.5 respectively.
The average returns by these 3 companies are 16%, 23% and 18% for X, Y and Z respectively.
The risk free rate is 6% per annum and rate of return in market is 14% per annum.
You are required to compute the portfolio  and the average return on portfolio. Also use
CAPM and determine the rate of return expected on such portfolio.
Determine portfolio  (alpha) and conclude whether the portfolio is favourable or
unfavourable. Would you advice any change in the portfolio. If yes, then suggest the effect
of such change assuming that the investor is required to retainat least Rs.1,00,000 on each
security.

CA FINAL – SFM
Consider the following Securities for designing a portfolio:
Securities Rate of Return (%) 
A 11 1.25
B 12 1.25
C 10 1.25
D 16 6.80
E 16 8.10
F 16 7.90
G 20 16.00
Suggest the investor regarding the appropriate securities that should be selected out of the
above seven.
RM has the following position in cash segment of the stock exchange. He is interested in
reducing risk to the extent given in the following lines Index futures. Suggest :
1. RM has a long position on cash market of Rs. 50 lakhs on the Right Ltd. the beta of
the Right Ltd. is 1.25. Hw wants to reduce his risk by 20%.
2. RM has a short position on the cash market of Rs. 20 Lakhs of wrong Ltd. the beta of
wrong Limited is 0.90. He wants to reduce his risk by 10%.
3. RM has a short position on the cash market of Rs. 20 lakhs of the Fair Ltd. the Beta of
the Fair Ltd. is 0.75. He wants to reduce his risk by 20%.
Questions 51 [May 2010 – 10 Marks]

A Ltd. has an expected return of 22% and standard deviation of 40%. B Ltd. has an expected
return of 24% and standard deviation of 38%. A Ltd. has a beta of 0.86 and B Ltd. a beta of
1.24. The correlation coefficient between the return of A Ltd. and B Ltd. is 0.72. The
standard deviation of the market return is 20%. Suggest:
1. Is investing in B Ltd. better than investing in A Ltd.?
2. If you invest 30% in B Ltd. and 70% in A Ltd. what is your expected rate of return and
portfolio standard deviation?
3. What is the market portfolios expected rate of return and how much is the risk-free
rate?
4. What is the beta of Portfolio if A Ltd.'s weight is 70% and B Ltd.'s weight is 30%?
You hold one stock A with a standard deviation of 20%. You are thinking about buying
another stock B with a standard deviation of 30%. You will hold these two stocks in a
portfolio, with 50% of your money invested in each. Stock B has a correlation coefficient of
0.2 with stock A. Your friend says that adding a stock with higher standard deviation B than
stock A will result in a riskier portfolio than just holding 'A’ alone. Is he right? That is, will
your portfolio of A & B be riskier than just stock A?
Questions 53 [PM] [May 11 – 5 Marks]

Mr. Tempest has the following portfolio of four shares:
Name Beta Investment? Lakh

CA FINAL – SFM
Oxy Rin Ltd. 0.45 0.80

Boxed Ltd. 0.35 1.50
Square Ltd. 1.15 2.25
Ellipse Ltd. 1.85 4.50
The risk free rate of return is 7% and the market rate of return is 14%.
Required:
1. Determine the portfolio return
2. Calculate the portfolio beta
Questions 54 [PM]
Amal Ltd. has been maintaining a growth rate of 12% in dividends. The company has paid
dividend @ Rs 3 per share. The rate of return on market portfolio is 15% and the risk-free
rate of return in the market has been observed as10% The beta co-efficient of the
company's share is 1.2.
You are required to calculate the expected rate of return on the company's shares as per
CAPM model and the equilibrium price per share by dividend growth model.
Questions 55 [PM] [Nov 7 – 8 Marks]

XYZ Ltd. has substantial cash flow and until the surplus funds are utilized to meet the future
capital expenditure, likely to happen after several months, are invested in a portfolio of
short-term equity investments, details for which are given below:
Investment No. of shares Beta Market price per Expected dividend
share (Rs.) Yield
I 60,000 1.16 4.29 19.50%
II 80,000 2.28 2.92 24.00%
III 1,00,000 0.90 2.17 17.50%
IV 1,25,000 1.50 3.14 26.00%
The current market return is 19% and the risk free rate is 11%. Required to:
a. Calculate the risk of XYZ’s short-term investment portfolio relative to that of the
market;
b. Whether XYZ should change the composition of its portfolio.

A company choice of investments between several different equity oriented mutual funds.
The company has an amount of Rs.1 crore to invest. The details of the mutual funds are as
follows:
Mutual Fund Beta
A 1.6
B 1.0
C 0.9
D 2.0
E 0.6
Required :
1. If the company invests 20% of its investment in the first two mutual funds and an
equal amount in the mutual funds C, D and E, what is the beta of the portfolio?
2. If the company invests 15% of its investment in C, 15% in A, 10% in E and the balance
in equal amount in the other two mutual funds, what is the beta of the portfolio?

CA FINAL – SFM
3. If the expected return of market portfolio is 12% at a beta factor of 1.0 what will be
the portfolios' expected return in both the situations given above?

Your client is holding the following securities:
Particulars of Cost Dividends/Interest Market price Beta
Securities Rs. Rs. Rs.
Equity Shares:
Gold Ltd. 10,000 1,725 9,800 0.6
Silver Ltd. 15,000 1,000 16,200 0.8
Bronze Ltd. 14,000 700 20,000 0.6
GOI Bonds 36,000 3,600 34,500 1.0
Average return of the portfolio is 15.7%, calculate:
1. Expected rate of return in each, using the Capital Asset Pricing Model (CAPM).
2. Risk free rate of return.

A holds the following portfolio:
Share/Bond Beta Initial Dividends Market Price
Price Rs. at end of year
Rs. Rs.
Epsilon Ltd. 0.8 25 2 50
Sigma Ltd. 0.7 35 2 60
Omega Ltd. 0.5 45 2 135
GOI Bonds 0.99 1,000 140 1.005
Calculate:
1. The expected rate of return on his portfolio using Capital Asset Pricing Method
(CAPM)
2. The average return of his portfolio. Risk-free return is 14%.

Your client is holding the following securities:
Particulars of Cost Dividends Market Price BETA
securities Rs. Rs. Rs.
Equity Shares:
Co. X 8,000 800 8,200 0.8
Co. Y 10,000 800 10,500 0.7
Co. Z 16,000 800 22,000 0.5
PSU Bonds 34,000 3,400 32,300 1.0
Assuming a Risk-free rate of 15%, calculate:
1. Expected rate of return in each, using the Capital Asset Pricing Model (CAPM)
2. Average return of the portfolio.

An investor has two portfolios known to be on minimum variance set for a population of
three securities A, B and C having below mentioned weights:.

CA FINAL – SFM
WA WB WC
Portfolio X 0.30 0.40 0.30
Portfolio Y 0.20 0.50 0.30
It is supposed that there are no restrictions on short sales.
(i) What would be the weight for each stock for a portfolio constructed by investing Rs
5,000 in portfolio X and Rs 3,000 in portfolio Y?.
(ii) Suppose the investor invests Rs 4,000 out of Rs 8,000 in security A. How he will allocate
the balance between security B and C to ensure that his portfolio is on minimum variance
set?

X Co., Ltd., invested on 1.4.2009 in certain equity shares as below:
Name of Co. No. of shares Cost (Rs)
M Ltd. 1,000 (Rs 100 each) 2,00,000
N Ltd. 500(Rs 10 each) 1,50,000
In September, 2009, 10% dividend was paid out by M Ltd. and in October, 2009, 30%
dividend paid out by N Ltd. On 31.3.2010 market quotations showed a value of Rs 220 and
Rs 290 per share for M Ltd. and N Ltd. respectively.
On 1.4.2010, investment advisors indicate (a) that the dividends from M Ltd. and N Ltd. for
the year ending 31.3.2011 are likely to be 20% and 35%, respectively and (b) that the
probabilities of market quotations on 31.3.2011 are as below:
Probability factor Price/share of M Ltd. Price/share of N Ltd.
0.2 220 290
0.5 250 310
0.3 280 330
You are required to:
1. Calculate the average return from the portfolio for the year ended 31.3.2010;
2. Calculate the expected average return from the portfolio for the year 2010-11; and
3. Advise X Co. Ltd., of the comparative risk in the two investments by calculating the
standard deviation in each case.

Ramesh wants to invest in stock market. He has got the following information about
individual securities:
Security Expected Return Beta Variance,
A 15 1.5 40
B 12 2 20
C 10 2.5 30
D 09 1 10
E 08 1.2 20
F 14 1.5 30
Market index variance is 10 percent and the risk free rate of return is 7%. What should be
the optimum
portfolio assuming no short sales?

CA FINAL – SFM

Expected return on two stocks for particular market returns are given in the following table:
Market Return Aggressive Defensive
7% 4% 9%
25% 40% 18%
You are required to calculate:
1. The Betas of the two stocks.
2. Expected return of each stock, if the market return is equally likely to be 7% to 25%.
3. The security Market Line (SML), if the risk free rate is 7.5% and market return is
equally likely to be 7% or 25%.
4. The Alphas of the two stocks.

A has portfolio having following features
Security B Random Error Weight

L 1.60 7 0.25
M 1.15 0.11 0.30
N 1.40 3 0.25
K 1.00 9 0.20
You are required to find out the risk of the portfolio if the standard deviation of the market index is
18%

Consider the following information on two stocks, A and B:
Year Return on A (%) Return on B (%)
2006 10 12
2007 16 18
1. The expected return on a portfolio containing A and B in the proportion of 40% and
60% respectively.
2. The standard deviation of return from each of the two stocks.
3. The covariance of returns from the two stocks.
4. Correlation coefficient between the returns of the two stocks.
5. The risk of a portfolio containing A and B in the proportion of 40% and 60%.

Mr.A is interested to invest Rs.1,00,000 in the securities market. He selected two securities
B and D for this purpose. The risk return profile of these securities is as follows:
Security Risk () Expected Return - E(R)
B 10% 12%
D 18% 20%
Co-efficient of correlation between B and D is 0.15.
You are required to:
Calculate the portfolio risk and portfolio return of the following portfolios of B and D to be
considered by A for his investment.
1. 100 percent investment in B only;

CA FINAL – SFM
2. 50 percent of the fund invested in B and D both;

3. 75 percent of the fund in B and the rest 25 percent in D;
4. 25 percent of the fund in B and the rest 75 percent in D; and
5. 100 percent investment in D only.
Also indicate that which portfolio is the best for him from risk as well as return point of
view?
Questions 67 [May 1996]

As an investment manager you are given the following information
Initial Price Dividends Market Price at Beta risk Factor
the end
Cement Ltd 25 2 50 0.8
Steel Ltd. 35 2 60 0.7
Liquor Ltd. 45 2 135 0.5
Govt of India 1,000 140 1,005 0.99
Bonds
Rf = 14%. You are required to calculate
1. Expected rate of return on the investment in each case using CAPM
2. Average return on the portfolio
Arbitrage pricing theory model (aptm)
This model believes that the risk factor is not singular i.e., to say there are multiple risk
factors which must be factored for determining expected rate of return. These risk factors
can arise due to inflation rate, interest rate, GDP, Foreign Exchange Fluctuation,
Government Policies, etc. The risk of each factor is expressed by its  and based on  of
various risk factors, an overall risk premium is determined and added to the risk free rate.
The obtained result is the expected rate of return as per APTM.
Risk Free Rate 8%
Risk Premium for Interest Rate 2%
Risk Premium for Forex 0.5%
Risk Premium for GNP 3%
Risk Premium for Inflation 0.8%
The Betas of the company with respect to the above factors are as below:
1. Interest Rate  0.8
2. Forex  1.3
3. GNP  0.6
4. Inflation  1.25
Calculate the expected rate of return using APTM.
Questions 69 [PM]
Mr. Tamarind intends to invest in equity shares of a company the value of which depends
upon various parameters as mentioned below:

CA FINAL – SFM
Factor Beta Expected in % Actual value in %

Value
GNP 1.2 7.70 7.70
Inflation 1.75 5.50 7.00
Interest rate 1.3 7.75 9.00
Stock market 1.7 12.0
index 10.0
Industrial 1.00 7.50
production 7.0
If the risk free rate of interest be 9.25%, how much is the return of the share under Arbitrage
Pricing Theory?
Various models for evaluation of performance of a mutual

portfolio
1. Sharpe Ratio ---- ----- Reward to Variability
Excess Variance Excess Return / SD

Return
Rm  Rf
Sharpe’s Index for Market =
m
Rp  Rf
Sharpe’s Index for Portfolio =
p
2. Treynor Ratio ---- ---- Reward to Volatility
Excess Beta Excess Return / Beta

Return
Rm  Rf
Treynor’s Index for Market =
m
Rp  Rf
Treynor’s Index for Portfolio =
p
3. Jensons Alpha ---- ---- Ex-post Alpha
Actual Return – Required Return

Jensen's Alpha = Rp - [Rf + (Rm - Rf) P]
Question 70
Calculate Sharpe Ratio, Treynor Ratio and Jensons Ratio from the following information
A B
Return 25% 18% Rf = 6%
Beta 2.2 1.6 Rm = 10%
Variance 15% 12%
Question 71
''Consider the following pattern of returns of a mutual fund company on its portfolio as compared with
the rate of returns in market:
Year Rm Rp

CA FINAL – SFM
1 20 23
2 14 20
3 21 18
4 15 15
5 18 16
6 16 19
7 20 18
8 22 20
risk free rate is 10% per annum.
You are required to evaluate the performance of the mutual fund portfolio by using:
1. Sharper's Model
2. Treynor's Model 3. Jenson's Alpha
Question 72
Year Rm Rp
1 16 20
2. 15 22
3. 18 24
4. 19 21
5. 16 15
The risk free rate is 10% per annum. You are required to evaluate the performance of the mutual fund
portfolio by using:
1. Sharper's Model
2. Treynor's Model 3. Jenson's Alpha
Thank YOU ….

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CA FINAL – SFM

RISK, RETURN AND PORTFOLIO THEORY

Page 48 Compiled by Rahul Malkan(RM)

Risk Associated with investment

Compiled By Rahul Malkan(RM) Page 49

Question 9 [PM] [Nov 2009 – 8 Marks]

Significance and limitations of standard deviation

Page 50 Compiled by Rahul Malkan(RM)

Measure of relative risk (co-efficient of variation) (cv)

Covariance & Correlation

COVxy = ∑xy Where x = Average Value of X and y = Average Value of y

Compiled By Rahul Malkan(RM) Page 51

Concept of CAPM, Alpha () and Beta 

Meaning of Capital Asset Pricing Model (capm)

Question 15 [Nov 08 – 6 Marks]

Page 52 Compiled by Rahul Malkan(RM)

Question 16 [May 05 – 6 Marks]

Meaning of Alpha ()

Calculation of  by Direct Method

Compiled By Rahul Malkan(RM) Page 53

Calculation of  by Co-variance Method

Calculation of  by correlation Method

meaning of an investment portfolio

Page 54 Compiled by Rahul Malkan(RM)

An Investment Portfolio is a collection of investments, owned by an individual or

Measuring Portfolio Returns (RP)

“Return on Portfolio is the weighted average of returns of individual securities included in

Measuring Overall Portfolio Risk (p)

Compiled By Rahul Malkan(RM) Page 55

Questions 24 (For Your Practice)

Page 56 Compiled by Rahul Malkan(RM)

Year Return on A (%) Return on B (%)

Compiled By Rahul Malkan(RM) Page 57

Measuring Portfolio Beta ( p) and Alpha ()

Systematic and unsystematic risk

"Diversification can greatly reduce unsystematic risk from a portfolio."

Page 58 Compiled by Rahul Malkan(RM)

Beta & Leverages

Compiled By Rahul Malkan(RM) Page 59

Real Estate Development 8 Crores 1.8

Questions 32 [May 2002 – 4 Marks]

A Characteristic line exhibits regression relationship between the return on an investment

Page 60 Compiled by Rahul Malkan(RM)

Security Market Line

Capital Market Line

Questions 37 [Nov 2003 – 10 Marks] [PM]

Compiled By Rahul Malkan(RM) Page 61

Questions 38 [Nov 04 – 8 Marks] [PM]

Questions 39 [May 06 – 8 Marks] [PM]

Questions 40 [Nov 02 – 10 Marks] [PM]

Questions 41 [May - 04 – 8 Marks] [PM]

Page 62 Compiled by Rahul Malkan(RM)

Questions 42 [May - 04 – 8 Marks] [PM]

Questions 43 [May - 04 – 8 Marks] [PM]

Questions 44 [Nov - 07 – 8 Marks] [PM]

Questions 45 [Nov - 09 – 10 Marks] [PM]

Compiled By Rahul Malkan(RM) Page 63

Questions 46 [May - 03 – 8 Marks] [PM]

Page 64 Compiled by Rahul Malkan(RM)

Questions 51 [May 2010 – 10 Marks]

Questions 53 [PM] [May 11 – 5 Marks]

Compiled By Rahul Malkan(RM) Page 65

Oxy Rin Ltd. 0.45 0.80