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PORTFOLIO ANALYSIS 1
Introduction: 1
( )
Security Return: r A 1
Security Risk: ( σ A ) 2
Portfolio Investment: 3
Portfolio Analysis: 3
Portfolio Return: ( r P ) 3
Portfolio Risk: ( σ P ) 4
Portfolios: 15
Technical Terms: 17
Model questions: 18
Introduction:
The process of investment consists of two major tasks. (i) Security analysis and (ii)
Portfolio Management. Security analysis consists of examining the risk -return
characteristics of individual securities. Security analysis helps in the calculation of intrinsic
value of a security and identification of overpriced and under priced securities. Portfolio
management consists of examining the risk-return characteristics in the portfolio context. It
helps in the selection of the best possible portfolio from a set of feasible portfolios.
( )
Security Return: r A
Expected rate of return from an individual security ‘A’ is the weighted average of
possible outcomes of rates of return, where the weights are the probabilities. If a security is
expected to provide the possible rates of return with the probability of occurrence, as shown
( )
table 13.1 expected rate of return r A can be calculated as follows.
Table 13.1
1
Mild recession 0.20 6.0
i =1
r A = r1 p1 + r2 p 2 + + r3 p3 + − − − − − − − + rn p n
(
Variance = σ 2 = r1 − r A )
2
(
p1 + r2 − r A )
2
(
p 2 + − − − − − − − − rn − r A )
2
pn
= ∑ ri − r A
i =1
n
( )2
pi
Variance is the sum of the squared deviations multiplied by the probability of occurrence.
σ 2 = (-3.0 - 10.3)2 0.05 + (6.0 - 10.3)2 0.20 + (11 – 10.3)2 0.50 + (14 – 10.3)2 0.20
= 19.31%
Standard deviation = σ = σ 2 = ∑ n ri − r A pi
i =1
( )
= 19.31 = 4.39%
2
Portfolio Investment:
Individually securities possess risk. The future return expected from a security
varies and the variability of returns is risk. Rarely we find investors putting all their wealth in
one single security. Investors are risk averse. They try to maximise their return given their
risk taking ability or alternatively, investors will try to minimise the risk given their required
rate of return. Investors follow a financial dictum “NOT TO PUT ALL THE EGGS IN ONE
BASKET”. It is believed that if money is invested in several securities simultaneously, the
loss in one will be compensated by the gain in others. As a result investors put their money
in more than one security or a combination of securities, which is known as portfolio
investment. The group of securities held together as an investment is known as “Portfolio”.
The objective of portfolio investment is to spread and minimise risk.
Investor identifies the securities in which he would like to invest. He estimates the
risk-return characteristics of these securities. He develops number of portfolios from the
given set of securities. For each alternative portfolio investor determines the expected return
and risk. The process of determining the portfolio return and portfolio risk is known as
portfolio analysis.
Portfolio Return: ( r P )
r A = 15% r B = 20% r c = 8%
Proportion
1 2 3 4 5
of
3
Investment
You are provided with five alternative portfolios in table 13.2 where W A indicates the
proportion of investment in security A, W B indicates the proportion of investment security B
and so on. For example, if we consider portfolio ‘3’, investment in security ‘A’ is 10%, ‘B’ is
20% and ‘C’ is 70%, the expected portfolio return will be.
r P3 = WA r A + WB r B + Wc r c
r P = ∑ n wk r k
k =1
Where
Portfolio risk is measured by the standard deviation of the portfolio return ( σ P ). The
standard deviation of an individual security measures the riskiness of an individual security
( σ A , σ B . . . . σ n ). For measureing portfolio risk, the riskiness of each security with in the
Two key concepts in portfolio analysis are (1) covariance and (2) correlation
coefficients. Covariance is a measure which reflects both the variance of a security’s returns
and the tendency of those returns to move up or down. For example, the covariance
between securities A and B tells us whether the returns on the two securities tend to rise or
4
fall together. Covariance is a measure of the general movement relationship between the
two security returns.
i =1
Where
-4 10 -40 -4.0
COVAB -10.8
5
r B = rB1 p 1 + rB2 p 2 + rB 3 p3 + rB 4 p 4 + rB 5 p5 = 10.0%
(8-10)(15-10)0.2 + (6-10)(20-10)0.1
= -10.8
COVAB = -10.8
both move counter to one another the product of the deviations would be negative. If both
fluctuate randomly the product may be positive or nagetive and sum of the products may
near “Zero”.
COV AB
rAB =
σ Aσ B
Where rAB = Coefficient of correlation between A and B
6
Variance of B = σ 2 B = (0.8)20.1 + (0.4)20.2 + (0.1)20.4 + (5)20.2 + (10)20.1
= 6.40 + 3.2 + 0.4 + 5 + 10
= 25
Standard deviation = σ B = σ 2 B = 5%
COV AB
rAB =
σ Aσ B
− 10.8 − 10.8
= = = - 0.99
(2.19(5) 10.95
The sign of the correlation coefficient is the same as the sign of the covariance. A
positive sign means that the returns of securities move together, a negative sign indicates
that they move in opposite direction and if it is close to zero, they move independently of one
another.
COVAB = rAB σ A σ B
The variance (risk) of a portfolio ( σ 2 P ) is not simply a weighted average of the variances
of the individual securities in the portfolio. The risk of a portfolio is sensitive to
The variance of portfolio with only two securities in it may be calculated with the following
formula.
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σ 2 P = W 2 Aσ 2 A + W 2 Bσ 2 B + 2W AWB rABσ Aσ B
Where
σ 2 P = Portfolio variance
W A = Proportion of funds invested in security ‘A’
WB = Proportion of funds invested in security ‘B’
σ 2 A = Variance of security A
σ 2 B = Variance of security B
rAB = Coefficient of correlation between returns of securities A and B
σ A = Standard deviation of security A
σ B = Standard deviation of security B
σP = σ 2P
Example: A and B securities have the following risk return characteristics. The correlation
coefficient between A and B is – 0.6.
=(0.25)2(20)2+(0.75)2(40)2+2(0.25)(0.75)(-0.6)(20)(40)
= 25 + 900 – 180
= 745
= 745
= 27.29%
8
Various situations are analysed here to see whether risk an be inimised
(a) When can risk be eliminated:
Risk can be totally eliminated only if the third term ( 2W AWB rA Bσ Aσ B ) is equal
σB
i.e., WA = σ A + σ B
Let us illustrate with an example. The return on securities A and B and standard
deviations of A and B are as follows.
r A = 9% r B = 9% σ A = 2% σ B = 4%
rAB = -1.0
σB 4 4 2
WA = = = = = 0.67
σ A +σB 2+4 6 3
2 1
then WB = 1 - = = 0.33
3 3
Therefore, portfolio risk ( σ P ) can be brought down to zero by skillfully balancing the
proportions of the portfolio to each security.
9
Some combinations of two securities (A and B) will provide a smaller σ P than either
security taken alone, so long as the correlation coefficient is less than the ratio of the smaller
standard deviation to the larger standard deviation.
σA
rAB 〈
σB
When the security returns are perfectly positively correlated with a correlation
coefficient of +1.0 the following formula can be applied.
σ 2 P = W 2 Aσ 2 A + W 2 Bσ 2 B + 2W AWBσ Aσ B
The expression is similar to that of (a+b)2 = a2+2ab+b2
therefore σ 2 P = [ W A σ A + WB σ B ]2
When security returns are perfectly positively correlated the portfolio risk ( σ P )
is the weighted average of the standard deviations of the individual securities. It is
not possible to reduce risk through diversification.
If the correlation coefficient between two securities is –1.0, the returns move
in exactly opposite direction.
Then σ 2 P = W 2 Aσ 2 A + W 2 Bσ 2 B − 2W AWBσ Aσ B
∴ σ 2 P = [ W A σ A + W B σ B ]2
10
Portfolio risk can be minimised or totally eliminated if the returns of two
securities are perfectly negatively correlated.
If the correlation coefficient is zero [ rAB = 0] then the returns of the two
securities are uncorrelated.
If rAB = 0, then
σ 2 P = W 2 Aσ 2 A + W 2 Bσ 2 B
σ P = σ 2 p = W 2 Aσ 2 A + W 2 Bσ 2 B
We have discussed situations where rAB = +1.0, rAB = -1.0 and rAB = 0. In
other cases, the proportion of securities A and B would result in minimum risk. That
portfolio can be arrived at by simplifying the equation for portfolio variance.
σ 2 P = W 2 Aσ 2 A + W 2 Bσ 2 B + 2W AWB rABσ Aσ B
σ 2 B − σ Aσ B rA B
WA =
σ 2 A + σ 2 B − 2σ Aσ B rA B
Variance of B - COVAB
=
Var of A + Var of B - 2 COVAB
σ 2 B − COVAB
=
σ 2 A + σ 2 B − 2 COVAB
WB = (1 - W A )
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Let us try to understand situations b,c,d and e with the help of examples.
( )
Suppose security A has an expected rate of return of r A 5% and standard
( )
deviation of return σ A 4% , while security B has expected return of r B 8% and the
standard deviation of (σ B ) 10%. Let us work with three different assumed degrees of
correlation rAB = +1.0, rAB = 0 and rAB = -1.0 and develop the portfolios expected
r P = W A r A + WB r B
σ P = W Aσ A + WBσ B
σ P = W 2 Aσ 2 A + W 2 Bσ 2 B
σ P = W Aσ A − WBσ B
Table 13.4 Portfolio Return and portfolio risk under different degrees of correlation.
Proportion of portfolio rAB = +1.0 rAB = 0 rAB = -1.0
Security A Security B rP σP rP σP rP σP
(WA ) ( WB (%) (%) (%) (%) (%) (%)
1.00 0.00 5.00 4.00 5.00 4.00 5.00 5.0
0.75 0.25 5.75 5.50 5.75 3.90 5.75 0.5
0.50 0.50 6.50 7.00 6.50 5.40 6.50 3.0
0.25 0.75 7.25 8.50 7.25 7.60 7.25 6.5
0.00 1.00 8.00 10.0 8.00 10.0 8.00 10.0
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the inability of a portfolio of perfectly positively correlated securities to serve as a
means to reduce risk.
The segment labeled rAB = -1.0 shows that with perfect negative correlation,
portfolio risk can be reduced to zero at point ‘C’.
Exercise:
You are evaluating an investment in two companies whose post ten years of
returns are as follows.
What percentage of investment in each would have regulated in the lowest risk?
Solution:
Return Return
on on (r −rA )
Year Security Security rA i - r A rB i - r B (r Ai −rA ) (r
2
Bi − rB ) (r
2 Ai
− rB )
A (rA i ) B (rB i ) Bi
8 21 18 +6 +3 36 9 18
13
9 18 27 +3 +12 9 144 36
10 6 10 -9 -5 81 25 45
TOTAL 150 150 -60 -61 1954 2038 1874
II. Variance σ 2 ( )
n
(
∑ rA i − r A )
2
1954
σ 2A = i −1 = = 19.54
N 10
n
(
∑ rB i − r B )
2
2038
σ 2B = i −1 = = 203.8
N 10
σA = 195.4 = 13.98%
σB = 203.8 = 14.28%
V. Correlation ( rAB )
14
σ 2 B − COV AB 203.8 − 187.4 16.4
WA = = = = 0.64
2 2
σ B + σ A − 2COV AB 195.4 + 203.8 − 2(187.4) 399.2 − 374.8
WB = 1 - WA = 1 - 0.67 = 0.33
If 67% of the money is invested in A and 33% in B, the portfolio risk would be
minimum.
= 192.92
= 13.9%
Portfolios:
If more number of security are added to a portfolio, the risk of the portfolio ( σ p )
decreases and becomes smaller and smaller. Security returns are never perfectly correlated
we will never find securities which are neither perfectly negatively correlated or perfectly
positively correlated. We will also not come across a situation where securities are
uncorrelated with zero correlation coefficient. They will either negatively or positively
correlate. Benefits of diversification are limited. Portfolio risk ( σ p ) decreases as the
The total risk of an individual security comprises of two components. The variance
caused by market forces is called market risk or systematic risk. The variance caused by
company specific factors is called unsystematic risk. Unsystematic risk is diversifiable where
as systematic risk is not diversifiable. As the number of securities increases in a portfolio the
unsystematic risk devises. Fig 13.2 presents the two components of risk. Risk redaction
stops once the unsystematic risk is eliminated.
When the portfolio has more than two securities, the expected return of a portfolio is
the weighted average of the returns of individual securities in the portfolio, the weights being
the proportions of investment in each securities
r P = W1 r 1 + W2 r 2 + − − − − − − +W N r N
= ∑ WK r K
n
K =1
15
r K = the expected return of each security [K= 1,2,3, - - - N]
N = No. of securities in a portfolio
If there are three securities (A,B & C) in portfolio risk ( σ p ) can be calculated by using
σp=
W A2σ A2 + WB2σ B2 + WC2σ C2 + WD2σ D2 + 2W AWB COV AB + 2WBWC COV BC + 2WCWD COVCD + 2W AWC COV AC + 2W AWD COV AD + 2W BWD COVBD
Correlation Coefficient
What are portfolio risk and return if the amounts invested are 20% in stock A, 40% in
stock B and 40% in stock C.
Solution:
= 10%
= (0.2)2(10)2+(0.4)2(15)2+(0.4)2(5)2 + 2(0.2)(0.4)(0.3)(10)(15)
+ 2(0.4)(0.4)(0.4)(15)(5) + 2(0.2)(0.4)(0.5)(10)(5)
= 64.8
16
Portfolio risk (standard deviation) = σ p
= σ 2p = 64.8 = 8.0%
Exercise 13.3 From the following data calculate portfolio return and portfolio risk
Expected Standard Proportion of
Security
return deviation funds invested
ACC 8.89 19.55 0.10
TCS 5.12 7.99 0.40
HLL 3.42 6.18 0.50
Solution:
Portfolio Return = rp
= (8.89)(0.10)+(5.12)(0.40)+(3.42)(0.50)
= 4.65%
Portfolio Return = σ 2p
= (0.1)2382.09+(0.4)263.82+(0.5)238.25
+ 2(0.1)(0.4)68.73
+2(0.4)(0.5)68.87
+22(0.1)(0.5)39.87
σ 2p = 60.628
σp = 7.79%
Technical Terms:
17
• Correlation Coefficient: A statistical measure that in dictates the similarity and
dissimilarity in the behaviour of the securities
Model questions:
4. Stock R and S display the following returns over the past two years?
Return on
Year
Stock R (%) Stock S (%)
1 10 12
2 16 18
What is the expected return and the risk on a portfolio made up of 40% of R
and 60% of S?
5. The returns of two securities, (a) Ranbaxy and (b) Polaris Soft are given
below
Stock A Stock B
Expected return 14% 20%
Standard deviation 8% 11%
Coefficient of Correlation
What is the expected return and risk of a portfolio in which A and B are
equally weighed?
*****
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