MARKOWITZ

PORTFOLIO THEORY
 Introduction
 The basic portfolio model was developed by Harry Markowitz
(1952, 1959), who derived the expected rate of return for a
portfolio of assets and expected risk measure.

 He showed that variance of the rate of return was a meaningful

measure of portfolio under a set of reasonable assumptions.

 He derived the formula for computing the variance of a

portfolio.

 This indicated the importance of diversifying investments to

reduce the total risk of a portfolio and also how to diversify.
 Assumptions
 Investors consider each investment alternative as being
represented by a probability distribution of expected returns
over some holding period.

 Investors maximise one-period expected utility, and their

utility curve demonstrate diminshing marginal utility of
wealth.

 Investors estimate the risk of the portfolio on the basis of the

variablilty of expected returns.
 Assumptions
 Investors base decisions solely on expected return and risk, so
their utility curves are a function of expected return and the
expected variance (or standard deviation) of returns only.

 For a given risk level, investors prefer higher returns to lower

returns. Similarly, for a given level of expected return, prefer
less risk to more risk.
 Alternate measures of risk

 One of the best known meaures of risk is variance or standard

deviation of expected returns.

 It is a statistical measure of the dispersion of returns around

the expected value whereby a larger variance or standard
deviation indicates greater dispersion.

 The idea being that more dispersed the expected returns, the
greater is the uncertanity and risk regarding future expected
returns.
 Alternate measures of risk

 Another measure of risk is the range of returns

 In this measure of risk, it is assumed that a larger range of

expected returns, from the lowest to the highest expected
return, means greater uncertanity and risk regarding future
expected returns.
 Alternate measures of risk
Although there are numerous potential measures of risk, mostly
variance and standard deviation of returns is used because:

 This measure is somewhat intuitive

 It is correct and widely recognised risk measure

 It has been used in most of the theoretical asset pricing

models
Calculation of Variance (Standard
Deviation) of Returns for
Individual Investment

Variance = σ2 = ∑[Ri - E(Ri)]2 Pi

where, Ri = possible rate of return

E(Ri) = expected rate of return
Pi = probability of the possible rate of return Ri

Standard Deviation = σ = √∑[Ri - E(Ri)]2 Pi

 Variance (Standard Deviation) of
Returns for Portfolio
 Covariance is a measure of the degree to which two variables
move together relative to their individual mean values over
time.

 In portfolio analysis, usually covariance of rate of return is

considered rather than prices or some other variable.

 A positive covariance means that the rate or return for two

investments tend to move in the same direction relative to their
individual means during the same time period.
CAPITAL MARKET
THEORY
 Development of Capital
market theory
• Capital market theory is generalized
theory of capital asset pricing under
conditions of uncertainty from the
Markowitz portfolio theory.

• Williams Sharpe (1964)

• Lintner (1965) and Mossin (1966)
Assumptions:
• All investors are efficient investors
who want to target point on the
efficient frontier.
• Investors can borrow or lend money
at the risk free rate of return (RFR).
• All investors have homogeneous
expectations
• All investors have the same one-
period time horizon such as one
month, six months, or one year.
Cont’d
• All investment is infinitely divisible,
which means that it is possible to
buy or sell fractional shares of any
assets or portfolio.
• There are no taxes or transaction
cost involved in buying or selling
assets.
• There is no inflation or any change
in interest rates, or inflation is fully
anticipated.
• Capital markets are in equilibrium.
Risk Free Asset
• As note assumptions of a risk free
assets in the economy is critical to
asset pricing theory. Therefore this
sections explains the meaning of a
risk free assets and shows the effect
on the risk and return measures
when this risk free asset is combined
with a efficient portfolio
Both the expected return and the
standard deviation of return for a
portfolio are linear combinations.
Possible portfolio returns and
risks looks like a straight line
between the two assets.
Capital assets pricing model
CAPM is a model that indicates what
should be the expected or required
rates of return on risky assets. This
transition is important because it
helps to value an assets by providing
an appropriate discount rate to use
in any valuation model.
 Security market line
SML visually represent the
relationship between risk and the
expected or required rate of return
on an assets. SML together with
estimates for the return on risk free
assets and on the market portfolio,
can generate expected or required
rates of return for any asset based
on its systematic risk.
Multi-factor risk model
 In this model two general approaches
have been employed in the factor
identification process

 Macroeconomic Factors

 Microeconomic Factors
 Macroeconomic Factors

• Factors that attempt to capture

variations in the assets cash flows
and investment returns
• These factors are external and
influences the share prices
Eg:
Changes in inflation rate
Changes in the GDP rate
 Burmeister,Roll and Ross
analysed 5 risk exposures
– Confidence Risk: based on unanticipated changes in
investors to take on investment risk

– Time Horizon Risk: Unanticipated changes in investors

desired time to receive payouts

– Inflation Risk: Based on a combination of unexpected

components of short term and long term inflation rates

– Business Cycle Risk: unanticpated changes in the level

of overall business activity

– Market Timing Risk: A part of risk associated in the

stock market index
 Microeconomic Factors
• Microeconomic factors is also called as the Characteristic Based
Approach Proposed by Fama and French in 1993

• Rf is the risk-free return rate, and

• Km is the return of the whole stock market.
• The "three factor" β is analogous to the classical β but not equal to
it, since there are now two additional factors to do some of the work.
• SMB stands for "small (market capitalization) minus big" and
• HML for "high (book-to-price ratio) minus low"; they measure the
historic excess returns of small caps over big caps and of value
stocks over growth stocks.
BARRA :A leading risk forcasting and
investment consulting firm has defined
various micro economic risk factors as
follows

 Volatility
 Momentum
 Size
 Trading activity
 Growth
 Earnings Yield
 Value
 Dividend yield
 Leverage
 Limitations
 It is developed with little theoretical
guidance as to the true nature of the
risk –return relationship

 It is a Mathematical model and so

specialist can only use it
 Thank You

for your patience

Functions of Stock Exchange
Introduction

On any Stock Exchange, there are members

who deal with client orders, institutional
orders and in line business. Some brokers
specialize in the new issues market and
some in badla financing. Some act as
jobbers, making two way offers to buy and
sell in selected shares. All members are
permitted to trade in the trading Ring.
Each member is permitted to have authorized
assistants up to a maximum number as fixed
by the Stock Exchange. The members do
trading on their own behalf of their clients.
If the member acts as a broker, he is doing a
retail business or purchase and sale
transactions for the customers.
If a member is doing wholesale business,
offering both purchase and sale prices (bid and
offers) to the other member brokers then he is
called a jobber. Both brokers and jobbers are
an essential part of the stock market
operations.
Specified and Non-specified Groups
The listed securities of the companies are
classified into a specified group and non-
specified group on the basis of certain criteria.
Those in the specified list should be fully paid-
up equity shares listed already on the exchange
for at least three years on the cash list and the
company’s paid-up equity capital should be
above Rs.10 crores.
Customer’s orders

The investor can place an order by telegram,

telephone, letter or in person. The order may
be for the purchase or sale of a specified
number of shares of a company at a specified
rate or range of prices. The member broker is a
custodian for the shares/ securities of his client
till they are sold or delivered.
The order to buy or sell may be given for a
fixed price or at a maximum or minimum price
range which is also called a limit order. Some
orders are ‘at best’ or ‘at the market price’.
The member broker has to execute the order at
the best obtainable price in the market on a
specified date.
Trading Ring

Trading on the stock exchange is officially

done in the trading ring for three hours from
11.30 a.m. to 2.30 p.m. or 12 noon to 3 p.m.
under electronic trading hours are extended
from 10 a.m. to 4 p.m. from Monday to
Friday. Trading before or after official hours is
called kerb trading. In the trading ring, space is
provided separately for specified or non-
specified sections.
The members or their authorized assistants
have to wear a badge or carry with them
identity cards given by the exchange to enter
the trading ring. They carry a sauda block
book, or confirmation memos, duly authorized
by the exchange and carry a pen with them.
Block book
Each page of the Sauda book or the Block
book taken to the floor of the stock Exchange
should be duly authorized by the stock
Exchange authorities. Under electronic trading
the computer software is designed to give all
the returns to be submitted to stock exchange
and the accounts to be maintained by the
broker himself.
Contract Note
It is important to ensure that the contract note
is written up on the day of the deal and posted
to the client. This is a proof that the contract
was executed on that day and not on any other
day since prices fluctuate everyday. Besides,
under article 43 (b) or (bb) of schedule 1 of the
Indian stamp Act, the broker must affix a
revenue stamp.
Thank You
Role and Functions of a
stock exchange
• Stock exchanges have always served a vital
role in bringing buyers and sellers together.
• Created jobs for workers and wealth for
investors.
• Stock exchanges also serve as the initial place
for companies to sell the shares of their
companies when they want to acquire capital.
• They also provide individuals the ability to
invest in companies.
• Stock exchanges help companies raise money
to expand.
The stock exchange market
has multiple role, its main
activities are two:
• To promote the savings.

• To provide liquidity to the investors

Function of the stock
exchange:
• Raising capital for businesses .
• Mobilizing saving for investment .
• Facilitating company growth .
• Redistribution of wealth .
• Creating investment opportunity of small
investor.
• Govt. capital- raising for development project
• Barometer of the economy
Other functions of the stock
exchange market as an
• To
organization
guarantee the legal and
are:
economic security of the
agreed contracts.
• To provide official information about the quantities
that are negotiated and of the quoted prices.
• To fix the prices of the securities according to the
fundamental law of the offer and the demand.
• To establish purpose of assisting, regulating and
controlling business of buying, selling and dealing in
securities.
• To provide market for the trading of
securities to individuals and organizations
seeking to invest their saving or excess
funds through the purchase of securities.
• To provide physical location for buying and
selling securities that have been listed for
trading on that exchange.
• To establish rules for fair trading practices
and regulates the trading activities of its
members according to those rules.
 Functions done by the
stock exchange market in
favour of the investor:
• It permits him the access to the profitable
activities of the big companies.
• It permits for the investor to have a
political power in the companies in which
he invests its savings due that the
acquisition of ordinary shares gives him the
right (among other things) to vote in the
general shareholders meetings of the
company in question.
• It offers the possibility of diversifying
your portfolio by enlarging the field
of strategy of investments due to
alternative options, as could be the
derived market, the money market,
etc.
• It offers liquidity to the security
investments, through a place in
which to sell or buy securities.
 With respect to the
function done by the stock
exchange market in favor
of the companies:
• It supplies them with the obtaining of long-term
funds that permits the company to make
profitable activities or to do determine projects
that otherwise wouldn’t be possible to develop
for lack of financing. Also, this funding signifies
a less cost than if obtained at other channels.
• The securities quoted at the stock exchange
market usually have more fiscal purpose
advantages for the companies.
• It offers to the company’s free
publicity, which in other way would
suppose considerable expenses. The
institution is objecting of attention of
the media (television, radio, etc.) in
case any important change in its
owners (the share holders).