1

Capital Markets and Portfolio Analysis

2

Introduction Capital market theory springs from the

notion that:• People like return

• People do not like risk

• Dispersion around expected return is a reasonable measure of risk

3

Role of the Capital Markets Definition Economic function Continuous pricing function Fair price function

4

Definition Capital markets trade securities with lives

of more than one year

Examples of capital markets• New York Stock Exchange (NYSE)• American Stock Exchange (AMEX)• BSE• NSE

5

Economic Function The economic function of capital markets

facilitates the transfer of money from savers to borrowers• E.g., mortgages, Treasury bonds, corporate

stocks and bonds

6

Continuous Pricing Function The continuous pricing function of capital

markets means prices are available moment by moment• Continuous prices are an advantage to investors

• Investors are less confident in their ability to get a quick quotation for securities that do not trade often

7

Fair Price Function The fair price function of capital markets

means that an investor can trust the financial system• The function removes the fear of buying or

selling at an unreasonable price

• The more participants and the more formal the marketplace, the greater the likelihood that the buyer is getting a fair price

8

The Life of every man is a diary in which he means to write one story, and writes

another; and his humblest hour is when he compares the volume as it is with what he

vowed to make it.

- J.M. Barrie

9

Investments Traditional investments covers:

• Security analysis– Involves estimating the merits of individual

investments

• Portfolio management– Deals with the construction and maintenance of a

collection of investments

10

Security Analysis A three-step process

1) The analyst considers prospects for the economy, given the state of the business cycle

2) The analyst determines which industries are likely to fare well in the forecasted economic conditions

3) The analyst chooses particular companies within the favored industries

• EIC analysis

11

The Portfolio Manager’s Job Begins with a statement of investment

policy, which outlines:• Return requirements

• Investor’s risk tolerance

• Constraints under which the portfolio must operate

12

The Six Steps of Portfolio Management

1) Learn the basic principles of finance

2) Set portfolio objectives

3) Formulate an investment strategy

4) Have a game plan for portfolio revision

5) Evaluate performance

6) Protect the portfolio when appropriate

13

Low Risk vs. High Risk Investments (cont’d)

1) Earns 10% per year for each of ten years (low risk)

• Terminal value is $25,937

2) Earns 9%, -11%, 10%, 8%, 12%, 46%, 8%, 20%, -12%, and 10% in the ten years, respectively (high risk)

• Terminal value is $23,642

The lower the dispersion of returns, the greater the terminal value of equal investments

14

Background, Basic Principles, and Investment Policy (cont’d)

There is a distinction between “good companies” and “good investments”• The stock of a well-managed company may be

too expensive• The stock of a poorly-run company can be a

great investment if it is cheap enough

15

Background, Basic Principles, and Investment Policy (cont’d)

The two key concepts in finance are:1) A dollar today is worth more than a dollar

tomorrow

2) A safe dollar is worth more than a risky dollar

These two ideas form the basis for all aspects of financial management

16

Background, Basic Principles, and Investment Policy (cont’d)

Setting objectives• It is difficult to accomplish your objectives

until you know what they are

• Terms like growth or income may mean different things to different people

17

Portfolio Management Passive management has the following

characteristics:• Follow a predetermined investment strategy

that is invariant to market conditions or

• Do nothing

• Let the chips fall where they may

18

PART THREEPortfolio Management

Active management:• Requires the periodic changing of the

portfolio components as the manager’s outlook for the market changes

8 - 19

Measuring ReturnsDollar Returns

Investors in market-traded securities (bonds or stock) receive investment returns in two different form:

– Income yield

– Capital gain (or loss) yield The investor will receive dollar returns, for example:

– $1.00 of dividends

– Share price rise of $2.00To be useful, dollar returns must be converted to percentage returns as a function of the original investment. (Because a $3.00 return on a $30 investment might be good, but a $3.00 return on a $300 investment would be unsatisfactory!)

8 - 20

Measuring ReturnsDollar Returns

Investors in market-traded securities (bonds or stock) receive investment returns in two different form:

– Income yield

– Capital gain (or loss) yield The investor will receive dollar returns, for example:

– $1.00 of dividends

– Share price rise of $2.00To be useful, dollar returns must be converted to percentage returns as a function of the original investment. (Because a $3.00 return on a $30 investment might be good, but a $3.00 return on a $300 investment would be unsatisfactory!)

8 - 21

Measuring ReturnsConverting Dollar Returns to Percentage Returns

An investor receives the following dollar returns a stock investment of $25:

– $1.00 of dividends

– Share price rise of $2.00

The capital gain (or loss) return component of total return is calculated: ending price – minus beginning price, divided by beginning price

%808.$25

$25-$27 return (loss)gain Capital

0

01

P

PP[8-2]

22

Return on a Single Asset Total

return = Dividend + Capital gain

Year-to-Year Total Returns on HLL Share

149.70

70.54

16.52 22.71

49.52

92.33

36.13

52.64

7.29 12.95

0.00

20.00

40.00

60.00

80.00

100.00

120.00

140.00

160.00

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Year

Tota

l R

etu

rn (%

)

1 1 01 011

0 0 0

Rate of return Dividend yield Capital gain yield

DIVDIV

P PP PR

P P P

23

Average Rate of Return The average rate of return is the sum of the

various one-period rates of return divided by the number of period.

Formula for the average rate of return is as follows:

1 2=1

1 1 = [ ]

n

n tt

R R R R Rn n

Measuring Average ReturnsGeometric Mean

Measures the average or compound growth rate over multiple periods.

11111(GM)Mean Geometric 1

321 -)]r)...(r)(r)(r [( nn[8-5]

CHAPTER 8 – Risk, Return and Portfolio Theory8 - 25

Estimating Expected Returns

The general formula

Where:ER = the expected return on an investment

Ri = the estimated return in scenario i

Probi = the probability of state i occurring

)Prob((ER)Return Expected 1

i

n

iir[8-6]

Estimating Expected Returns

Example:

This is type of forecast data that are required to make an ex ante estimate of expected return.

State of the EconomyProbability of Occurrence

Possible Returns on

Stock A in that State

Economic Expansion 25.0% 30%Normal Economy 50.0% 12%Recession 25.0% -25%

Estimating Expected Returns

Example Solution:

Sum the products of the probabilities and possible returns in each state of the economy.

(1) (2) (3) (4)=(2)×(1)

State of the EconomyProbability of Occurrence

Possible Returns on

Stock A in that State

Weighted Possible

Returns on the Stock

Economic Expansion 25.0% 30% 7.50%Normal Economy 50.0% 12% 6.00%Recession 25.0% -25% -6.25%

Expected Return on the Stock = 7.25%

Estimating Expected Returns

Example Solution:

Sum the products of the probabilities and possible returns in each state of the economy.

7.25%

)25.0(-25%0.5)(12% .25)0(30%

)Prob(r)Prob(r )Prob(r

)Prob((ER)Return Expected

332211

1i

n

iir

CHAPTER 8 – Risk, Return and Portfolio Theory8 - 29

Risk

Probability of incurring harm For investors, risk is the probability of earning

an inadequate return.• If investors require a 10% rate of return on a given

investment, then any return less than 10% is considered harmful.

30

Risk of Rates of Return: Variance and Standard Deviation

Standard deviation = Variance

2

2

1

1

1

n

tt

R Rn

Measuring RiskExample Using the Ex post Standard Deviation

Problem

Estimate the standard deviation of the historical returns on investment A that were: 10%, 24%, -12%, 8% and 10%.

Step 1 – Calculate the Historical Average Return

Step 2 – Calculate the Standard Deviation

%88.121664

664

4

404002564

4

2020162

15

)814()88()812()824(8)-(10

1

)(post Ex

22222

222221

2_

n

rrn

ii

%0.85

40

5

10812-2410 (AM) Average Arithmetic 1

n

rn

ii

32

Portfolio Return: Two-Asset Case The return of a portfolio is equal to the weighted

average of the returns of individual assets (or securities) in the portfolio with weights being equal to the proportion of investment value in each

asset. Expected return on portfolio weight of security × expected return on security

weight of security × expected return on security

X X

Y Y

33

Portfolio Risk: Two-Asset Case The portfolio variance or standard deviation depends on

the co-movement of returns on two assets. Covariance of returns on two assets measures their co-movement.

The formula for calculating covariance of returns of the two securities X and Y is as follows:Covariance XY = Standard deviation X ´ Standard

deviation Y ´ Correlation XY The variance of two-security portfolio is given by the

following equation:

2 2 2 2 2

2 2 2 2

2 Co var

2 Cor

p x x y y x y xy

x x y y x y x y xy

w w w w

w w w w