PORTFOLIO CONSTRUCTION

Dr S Sreenivasa Murthy Associate Professor, IPE

APPROACHES IN PORTFOLIO CONSTRUCTION - TRADITIONAL APPROACH - MARKOWITZ EFFICIENT FRONTIER APPROACH I TRADITIONAL APPROACH

DEALS WITH TWO MAJOR DECISIONS - DETERMINING THE OBJECTIVES OF THE PORTFOLIO - SELECTION OF SECURITIES TO BE INCLUDED IN THE PORTFOLIO

THI I (i)

TI

TO IX TEPS:

ANALYSIS OF -

ONSTRAINTS

(ii)

INCOME NEEDS - NEED FOR CURRENT INCOME - NEED FOR CONSTANT INCOME LIQUIDITY SAFETY OF THE PRINCIPAL TIME HORI ON TAX CONSIDERATION TEMPERAMENT

DETERMINATION OF OBJECTI ES - CURRENT INCOME ROWTH IN INCOME - CAPITAL APPRECIATION - PRESERVATION OF CAPITAL
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ST E PS I

T R A D IT I

A L A P PR O A C H

A N A LY SIS

N ST A IN TS

D ETER M IN A TI N

JEC TI ES

SELEC TI N

RT

LI

BOND AND C O M M O N STO C K

BOND

COM M ON STO C K

A SSESSM EN T

R ISK A N D R ET R N

D I ER SI IC A TI N

(i)

S E L E C T IO N O F T E -

O R T F O L IO

O B JE C T I E S A N D A S S E T M I R O W T O F IN C O M E A N D A S S E T M I C A P IT A L A P P R E C IA T IO N A N D A S S E T M I S A F E T Y O F P R IN C IP A L A N D A S S E T M I R IS K A N D R E T R N A N A L Y S IS D I E R S IF IC A T IO N - S E L E C T IO N O F IN D U S T R IE S - S E L E C T IO N O F C O M P A N IE S IN T E IN D U S T R Y - D E T E R M IN IN G T E S I E O F P A R T IC IP A T IO N

II

M ODERN APPROACH IN T H E M O D E R N A P P R O A C H , M A R K O W IT Z M O D E L IS USED M O R E IM P O R T A N C E IS G I E N T O T H E R IS K A N D R E T U R N A N A L Y S IS

PORTFOLIO M ARKO W ITZ M O DEL

SIM PLE DIVERSIFICATION PROBLEM S OF VAST DIVERSIFICATION
Wp

Diversification and Portfolio Risk

U nique Risk

M arket Risk

Total Risk

No. of stocks
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PURCHASE OF POOR PERFORMERS INFORMATION INADEQUACY HIGH RESEARCH COSTS HIGH TRANSACTION COSTS

THE MARKOWITZ MODEL ASSUMPTIONS THE INDI IDUAL INVESTOR ESTIMATES RISK ON THE BASIS OF VARIABILITY OF RETURNS FOR A GIVEN LEVEL OF RISK, INVESTOR PREFERS HIGHER RETURN TO LOWER RETURN. LIKEWISE, FOR A GIVEN LEVEL OF RETURN INVESTOR PREFERS LOWER RISK THAN HIGHER RISK.

CALCULATION OF RISK AND RETURN

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RISK AND RETURN WITH DIFFERENT CORRELATION

Rp
r = +1 r=0

D J

C
r = +0.5

r = -1
Wp

MARKOWITZ EFFICIENT FRONTIER

Rp By Cy Hy Dy Ey Fy
yI yG yA

UTILITY ANALYSIS A
UTILITY

RETURN

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INDIFFERENCE MAP AND EFFICIENT FRONTIER

Rp 14 13

R T

12 11

Wp

11

EFFICIENT FRONTIER WITH BORROWING AND LENDING (LEVERAGED PORTFOLIOS)

Rp
Borrowing

R
Lending

Wp

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THE SHARPE INDEX MODEL

Developed on the assumption that the return of a security is linearly related to a single index like market index. SINGLE INDEX MODEL Ri = Ei + Fi Rm + ei Where Ri Ei Fi Rm ei = = = = = expected return on security i' intercept of the straight line or alpha co-efficient slope of the straight line or beta co-efficient rate of return on market index error term
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The variance o securitys return iW

Fj W

2 m

2 ei 2 m

The covariance o returns between securities i and j, (Wij) Total Risk Systematic Risk = = Systematic Risk
2 Fi 2 Fi 2 m

Fj Fj W

Unsystematic Risk

Variance o market index W

Unsystematic Risk = ei
2

Total variance Systematic risk W i Systematic Risk Fj W

2 2 m 2

Then, Total Risk =

ei

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Portfolio Variance
N 2 Wp N 2 2

[7 xi Fi) W m ] i=1

[7 xi ei ]
i=1

Where,
2 Wp 2 W2m ej

= = = =

xi

Variance of the portfolio Expected variance of index Variation in Securitys return not related to the market index The portion of stock i in the portfolio

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Portfolio Return
N

Rp

7 xi (Ei +Fi Rm ) i=1

Portfolio Alpha
N

Ep
Where, Ep xi Ei N

7 xi Ei i=1
Value of the alpha for the portfolio Proportion of the investment on security i' Value of alpha for security i' The number of securities in the portfolio
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= = = =

SHARPES OPTIMAL PORTFOLIO - A model for the selection of appropriate securities in a portfolio - The selection of a stock is directly related to its excess return beta ratio Ri Rf --------Fi Where, Ri Rf Fi = = = The expected return on stock i' The return on a riskless asset The expected change in the rate of return on stock i' associated with one unit change in the market return

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Ranking of the stocks done on the basis of their excess return to beta The selection of the stocks depends on a unique cut-off rate. Al stocks with higher ratios of R i R f / F i are included and the stocks with lower ratios; are left off. The cut-off point is Ci = (R i R f) F i W m 7 -------------i=1 2 W ei ---------------------2 N Fi 2 1 W m 7 -----i=1 2 W ei
N 2

W here, 2 W m 2 W ei

= =

Variance of the market index Variance of stocks movement that is not associated with the movement of market index i.e., Unsystematic Risk
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CONSTRUCTION OF THE OPTIM AL PORTFOLIO

The percentage of funds to be invested in each security are estimated in the following manner.
i

Xi

--------N

7
i=1

Ri - Rf Fi ----- [--------- C] 2 W ei Fi Indicates the weights on each security and they sum up-to one Indicates the relative investment in each security
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Xi

CAPITAL ASSET PRICING MODEL (CAPM) AND ARBITRAGE PRICING THEORY (APT)
The CAPM: y Markowitz, William Sharpe, John Linter and Jan Mossin provided the basic structure for the CAPM model. y According to this theory, the required return of an asset will have a linear relationship with assets beta value i.e., undiversifiable for systematic risk.
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Assumptions of CAPM: y An individual seller or buyer cannot affect the price of a stock y Investors make their divisions only on the basis of the expected return, SDs and covariance at all pairs of securities. y Investors are assumed to have homogeneous expectations y The investor can lend or borrow any amount of funds at the riskless rate of interest y Assets are infinitely divisible y No transaction costs y No personal income taxes y Unlimited quantum of short sales is allowed

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Portfolio Return Rp = Rf Xf + Rm(1-Xf) Where, Rp Rp 1-Xf Rf Rm = = = = = Portfolio Return The proportion of funds invested in risk free assets The proportion of funds invested in risky assets The Risk free rate of return Return on risky assets

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Portfolio Risk (variance)

2 Wp

2 Wf

2 Xf

2 2 + W m (1-Xf) + 2 Covfm Xf

+ (1-Xf)

CAPITAL MARKET LINE (CML): CML represents linear relationship between the required rates of return for efficient portfolios and their standard deviations.

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R f (R m R f) E(R p) = -----------------Wm Where, E(R p) Rm Wm Wp Rp = = = =

Wp

Portfolio rate of return Expected return on market portfolio Standard deviation of market portfolio Standard deviation of the portfolio CML S

Rf

Wp
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S E C U R IT Y M A R K E T L IN E ( S M L )

S M L in d ic a te s th e ris k re tu rn tra d e o ff fo r in e ffic ie n t p o rtfo lio s a n d in d iv id u a l s e c u ritie s It h e lp s to d e te rm in e th e e x p e c te d ra te o f re tu rn fo r a g iv e n s e c u rity b e ta R f + F [E (R m ) R f ] Rp SM L Rm Rf S

E (R i ) =

0 E v a lu a tio n o f s e c u ritie s u s in g S M L

B e ta

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ARBITRAGE PRICING THEORY (APT)

y A model of asset pricing developed by Stephen Ross y Explains the nature of equilibrium in the asset pricing in a less complicated manner with fewer assumptions operational to CAPM
Arbitrage

y It is a process of carrying profit by taking advantage of differential pricing for the same asset y The Buying and Selling activities of the arbitrage reduces and eliminates the profit margin, brining the market price to the equilibrium

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Assumptions: y y y y The investors have homogeneous expectations The investors are risk averse and utility maximisers Perfect competition prevails in the market and There are no transaction costs

Arbitrage Pricing Equation In a single factor model, the linear relationship between the return R i and sensitivity b i is given by Ri Where, Ri Po bi Pi = Po + Pi bi

= = = =

Return from stock A Riskless rate of return The sensitivity related to the factor Slope of the arbitrage pricing line
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