Introduction

to
Investment Marketplace

Dr. Malaya Ranjan Mohapatra

Evaluation Scheme

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 Investment Process

▪ PORTFOLIO: COLLECTION OF INVESTMENT ASSETS

▪ ASSET ALLOCATION “Top-down” approach

Asset allocation followed by
Choice among broad asset classes (stock, bond, security analysis
real estate, commodities, and so on) “Bottom-up” approach
Investment based solely on the
▪ SECURITY SELECTION price-attractiveness

Choice of securities within each asset class

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Markets Are Competitive

• Risk-Return Trade-Off
• Higher-risk assets are priced to offer higher expected
returns than lower-risk assets
• Risk and expected return are positively correlated
• Efficient Markets
• Efficient markets: prices quickly adjust to all relevant
information
• There should be neither underpriced nor overpriced
securities

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 Markets Are Competitive

• Efficient Market Hypothesis (investment

strategies) – Fama, 1970
• Passive Management: calls for holding highly
diversified portfolio without spending effort or other
resources attempting to improve performance
through security analysis.
• Holding a highly diversified portfolio
• No attempt to find undervalued securities
• No attempt to time the market
• Active Management
• Finding mispriced securities
• Timing the market
Which one is better for improving the performance?
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 The Players

Financial Intermediaries: Pool and invest funds

Investment Companies
Roll of Government? Banks
Can be either borrowers or lenders Insurance companies
Credit unions
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Types of Securities Markets

Financial
Markets

Capital Money
Market Market

Primary Secondary
Market Market

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Money Market
• Money market is a type of market which trade in such securities which has a short maturity
periods. Such securities are often risk free.
Instruments Maturity Description
Treasury Bills 91, 182, & 364 Days Issued by RBI on behalf Government to meet liquidity shortfalls.
Cash Management Less than 91 days Issued by RBI on behalf Government of India to meet the temporary
Bills mismatch in the cash flows of the Government.

Collateralized 1 to 19 days launched by the Clearing Corporation of India Limited (CCIL) in 2003
Borrowing and to provide liquidity support to non-bank entities, who are restricted
Lending Obligation to access funds from the Call Money Market
(CBLO)
Certificates of 1 to 3 Years Certificates of Deposits (CDs) are short term tradable deposits
Deposits (CDs) issued by banks to raise funds.
Commercial Paper 7 days to 1 Year Companies and institutions raise short-term funds in the money
market through the issue of commercial paper (CP).
Commercial Bills 30, 60, and 90 days Commercial bills are also called “bills of exchange,” which are used
by firms for financing their working capital.
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Treasury Bills (T-Bills) Certificates of Deposit (CDs)
•Issuer: Government of India •Issuer: Banks and Financial Institutions
•Maturity: 91 days, 182 days, and 364 days •Maturity: 7 days to 1 year (for banks); up to 3 years
•Typical Yield: (for financial institutions)
• 91-day: ~6.75% •Typical Yield: ~7.00% – 7.75%
• 182-day: ~6.85% •Description: Time deposits issued in demat form,
• 364-day: ~7.00% offering higher returns than savings accounts.
•Description: Short-term government securities sold at a Tradable in the secondary market.
discount and redeemed at face value. Zero-coupon
instruments with no periodic interest.

Call and Notice Money

Commercial Papers (CPs) •Issuer: Interbank participants (Banks and PDs)
•Issuer: Corporates, Primary Dealers, Financial •Maturity:
Institutions • Call Money: Overnight
•Maturity: 7 days to 1 year • Notice Money: 2–14 days
•Typical Yield: ~7.25% – 8.50% (varies by credit rating) •Typical Rate: ~5.50% – 6.75% (fluctuates daily)
•Description: Unsecured short-term promissory notes •Description: Money lent or borrowed on an overnight
issued at a discount to face value. Used by companies to (call) or short-term (notice) basis in the interbank
meet short-term working capital needs. market.

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Capital Market

• It is a market for long term funds – both equity and debt – and fund raised
within and outside the country.

Market for the new

Primary Market
issue
Capital Market
Market for existing
Secondary Market or outstanding
securities traded.

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Securities
of Capital
Markets
The five most common
securities are:
Description
• Stocks: Also known as equities, stocks give the holder ownership over a
corporation. Stockholders have claims on assets, earnings, and voting rights.
• Bonds: Bonds are debt instruments corporations or governments use to raise
capital. Bondholders are creditors who receive interest payments and principal
repayment once the instrument matures.
• Derivatives: Derivatives are contracts whose value is based on an underlying asset,
index, or interest rate. This category includes options, futures, swaps, and more.
• Exchange-Traded Funds (ETFs): ETFs are securities that track an index or basket of
assets but trade on exchanges like stocks.
• Mutual Funds: Mutual funds are professionally managed investment funds that
pool money from many investors to purchase securities and build portfolios.

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Primary Issues
• IPO: An Initial Public Offering (IPO) is the process Primary Issues
through which a private company offers its shares to
the public for the first time, thereby becoming a
publicly traded company. Private
Public Issue Right Issue
Placement
• SME IPO: is a Small and Medium Enterprise (SME) IPO.
Stock exchanges offer SMEs a lateral entry into the
stock market through SME IPOs. An SME IPO is a way Initial Public Private
Offering (IPO) Placement
for a privately owned Small and medium enterprises
(SME) company to sell its shares to the public for the
first time and gets listed at BSE SME or NSE Emerge Follow-on
Preferential
Public Offer
platform. Companies with minimum post-issue capital (FPO)
Issue
of Rs 1 crore and a maximum of Rs 25 crores are
eligible for SME IPO in India. Qualified
Institutions
Placements

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 New IPOs
IPO_Issue IPO_Issue Size (No of IPO_Face IPO_Issue
Company Name Type IPO_Open date IPO_Close date IPO_Issue price 1 IPO_Issue price 2 IPO_Tick size shares) value price

Patil Automation Ltd. Book building 6/16/2025 6/18/2025 114 120 1 4149600 10 120

Samay Project Services Ltd. Book building 6/16/2025 6/18/2025 32 34 1 3120000 10 34

Aten Papers & Foam Ltd. Book building 6/13/2025 6/17/2025 91 96 1 3300000 10 96

Oswal Pumps Ltd. Book building 6/13/2025 6/17/2025 584 614 1 16212980 1 614

Oswal Pumps Ltd. Book building 6/13/2025 6/17/2025 584 614 1 16212980 1 614

Oswal Pumps Ltd. Book building 6/13/2025 6/17/2025 584 614 1 16212980 1 614

Oswal Pumps Ltd. Book building 6/13/2025 6/17/2025 584 614 1 16212980 1 614

Oswal Pumps Ltd. Book building 6/13/2025 6/17/2025 584 614 1 16212980 1 614

Monolithisch India Ltd. Book building 6/12/2025 6/16/2025 135 143 1 4103000 10 143

Jainik Power Cables Ltd. Book building 6/10/2025 6/12/2025 100 110 1 4663200 10 110

Sacheerome Ltd. Book building 6/9/2025 6/11/2025 96 102 1 4321200 10 102

Ganga Bath Fittings Ltd. Book building 6/4/2025 6/6/2025 46 49 1 6663000 10 49

3B Films Ltd. Fixed Price 5/30/2025 6/3/2025 50 1 6750000 10 50

IPO Process
• Appoint an Investment Bank
▪ Investment Bank – Lead the process (Book running lead manager)
▪ Syndicate members (when IPO size is huge one, lead manager appoint other institutes as syndicate
members)
• Due diligence & fillings
▪ Underwriting
▪ Red Hearing Prospectus
▪ Compliance & fillings
• Pricing
▪ Valuation
• Comparable (P/E, P/B, etc.)
• Discounted Cash Flow
▪ Fixed
▪ Book Building (The difference between floor price and cap price can be maximum 20%)

• Note: The company can revise the price band and bidding period will be extended maximum 3 days. So,
the total bidding period can extend upto 10 days.
IPO Process
• Listing of security
▪ Once the issue window close, the company has to list in stock exchange within 3 days.
 Book Building Process in IPO Determine IPO allotment Price

Bidder Price # of Shares

• Oswal Pump Ltd. A 207 8,28,96,480
• Total Number of shares: 16212980 B 206 9,28,96,789
• Share offered to Retail Investors: 81,68,905 C 205 10,28,96,576
• Price Range: ₹584 to ₹614 D 204 11,28,96,789
E 203 12,28,96,460
• Lot Size: 24
F 202 13,28,96,200
• Maximum number of allottee = 81,68,905/24 = 3,40,371
G 201 14,28,96,480
H 200 15,28,96,753
I 199 16,28,96,894
Investor Category Share Offered Allotment Process J 198 17,28,96,480
QIB 1,12,97,557 Pro-rata K 197 18,28,96,456
L 196 19,28,96,369
NII 33,89,267 Lottery
M 195 20,28,96,963
Retail Investors 81,68,905 Lottery
 Allotment process comprises
IPO Allotment pro-rate basis and lottery
system.

# of Application No. of Equity shares No. of Allottee # of Equity Shares

S.N. Category % of Total # of Shares applied % of Total Round Up
Received alloted per bidder per Category Allotted

1 72 8,50,000 87.82% 6,12,00,000 73.83% 72 100757.1985 100757 7254504

2 144 75,000 7.75% 1,08,00,000 13.03% 72 8890.341044 8890 640080
3 216 35,000 3.62% 75,60,000 9.12% 72 4148.825821 4149 298728
4 288 2,500 0.26% 7,20,000 0.87% 72 296.3447015 296 21312
5 360 1,450 0.15% 5,22,000 0.63% 72 171.8799269 172 12384
6 432 1,800 0.19% 7,77,600 0.94% 72 213.3681851 213 15336
7 504 750 0.08% 3,78,000 0.46% 72 88.90341044 89 6408
8 576 625 0.06% 3,60,000 0.43% 72 74.08617537 74 5328
9 648 365 0.04% 2,36,520 0.29% 72 43.26632641 43 3096
10 720 85 0.01% 61,200 0.07% 72 10.07571985 10 720
11 792 115 0.01% 91,080 0.11% 72 13.63185627 14 1008
12 864 220 0.02% 1,90,080 0.23% 72 26.07833373 26 1872
Randomly allot remaining (8260870 - 8260776) = 94 shares to category 2 to 12.

Total 9,67,910 100% 8,28,96,480 1,14,733 82,60,776

Follow on public offer (FPO)
• Follow on public offer or FPO is a way by which companies already listed on
the stock exchange issue shares to the public.

• News: The Securities and Exchange Board of India (SEBI) has approved Ruchi
Soya’s application for a Follow-on Public Offer (FPO). The market regulator
has approved the draft document of the company, owned by the Baba
Ramdev-led Patanjali Ayurveda, for an FPO of up to Rs 4,300 crore

©2018 McGraw-Hill Education

Secondary Market
• Secondary markets are where investors trade existing securities without the
involvement of the issuers. This market counts on the participation of:
▪ Organized stock exchanges (e.g., NSE, BSE)
▪ Brokers (e.g., ICICI direct, Groww, Zerodha)
▪ Clearing houses (e.g., Indian Clearing Corporation Ltd., Multi Commodity
Exchange Clearing Corporation Ltd., NSE Clearing Limited., and so on)
▪ Over-the-Counter (OTC) Markets: OTC trading occurs directly between
parties, not through an exchange. They work as private networks of broker-
dealers and financial institutions that exchange assets among them in a
relatively organized fashion.

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Type of Secondary Markets

• There are two broad categories of

secondary market:
• The organized exchanges: Stock
exchanges are centralized and regulated
marketplaces where securities (stocks,
bonds, derivatives) are listed and traded.
• Over the counter (OTC) market: OTC
markets are decentralized networks
where securities are traded directly
between parties, often via dealer
networks or electronic platforms.
Private placement
• Private placement is a capital-raising strategy where companies sell securities directly to
a select group of investors instead of through a public offering. This method is often chosen
for its efficiency and confidentiality.

• Preferential Allotment: Preferential allotment is the practice of issuing of securities to a

selected group of entities such as mutual fund companies, financial institutions or
promoters at a particular price.

• Qualified Institutional Placement: Qualified Institutional Placement (QIP) is a method by

which listed companies raise capital by issuing equities, or other equity convertible
securities to qualified institutional buyers. It is a common method of private placement
where the company does not dilute its management stake and also does not need to repeat
elaborate paperwork like it did during its IPO.

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 Derivatives

• A derivative is a security that gets

its value from the value of another
asset, such as commodity prices,
bond and stock prices, or market
index values

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Option
• Call Option:
• Right to buy underlying asset at the strike price
• Value of calls decreases as strike price increases

• Put Option:
• Right to sell underlying asset at the strike price
• Value of puts increase with strike price

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©2018 McGraw-Hill Education
Futures
• Futures Contracts: A contract between two parties where both parties agree to buy and sell
a particular asset of specific quantity and at a predetermined price, at a specified date in
future.

• Long position: A long position is a bet that an asset's value will increase over time. In
other words, when you take a long position, you buy an asset with the expectation that its
value will rise in the future. If the asset's value does increase, you can sell it for a profit.
Buy Low, Sell High

• Short position: A short position is a bet that an asset's value will decrease over time.
When you take a short position, you sell an asset that you don't own with the expectation
that its price will fall. If the asset's value does fall, you can buy it back at a lower price
and profit from the difference between the sale and purchase price. Sell High, Buy Low

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Features of a Perfect Capital Market
❖Absence of Entry Barrier

❖Large Number of Buyers and Sellers

❖Diverse investment opportunities

❖Capital formation

❖Market efficiency

❖Risk management

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Computation of Index
• Index like Sensex, Nifty are value-weighted index, where market capitalization of
each stock is multiplied with free-float factor to arrive at the modified market
capitalization.

• The final weight is computed based on modified market cap or free float market cap.

• Free-float shares = Shares outstanding – Restricted shares

𝑭𝒓𝒆𝒆 𝒇𝒍𝒐𝒂𝒕 𝒎𝒂𝒓𝒌𝒆𝒕 𝒄𝒂𝒑

• 𝑾𝒆𝒊𝒈𝒉𝒕 𝒐𝒇 𝒔𝒕𝒐𝒄𝒌 𝒊𝒏 𝑵𝒊𝒇𝒕𝒚 𝟓𝟎 =
𝑪𝒐𝒎𝒃𝒊𝒏𝒆𝒅 𝒇𝒓𝒆𝒆 𝒇𝒍𝒐𝒂𝒕 𝒎𝒂𝒓𝒌𝒆𝒕 𝒄𝒂𝒑 𝒐𝒇 𝟓𝟎 𝒔𝒕𝒐𝒄𝒌𝒔 𝒊𝒏 𝑵𝒊𝒇𝒕𝒚

Excel

• Excel

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 T H A N K YO U

© 2 0 1 8 M C G R A W - H I L L E D U C AT I O N
Investment Analysis
and Portfolio
Management

SESSION 2
How Securities are Traded
Types of Markets:
• Direct search
• Buyers and sellers seek each other
• Brokered markets
• Brokers search out buyers and sellers
• Dealer markets
• Dealers have inventories of assets from which they buy and sell
• Auction markets
• Traders converge at one place to trade
Type of Orders
• Market Order:
• Market orders are buy or sell orders that are to be executed immediately at the current
price.
• Executed immediately
• Trader receives current market price
• Price-Contingent Order:
• Traders specify buying or selling price
• A large order may be filled at multiple prices
Bid and Asked Prices

▪ Bid price: The highest price a buyer is willing to

pay for a stock or security in the market.

▪ Ask price: The lowest price at which a seller is

willing to transfer a stock or security.

▪ Example: Bid price: ₹150 and Ask price: ₹152

▪ It means if you want to purchase shares in the

company, then you have to pay ₹152 per share,
which is the lowest price or ask price in the ▪ The bid-ask spread is the difference between the
market. best ask price and the best bid price.

▪ Similarly, if you sell your shares, you will receive ▪ When the spread is low, it is called a tight spread,
₹150 per share, the highest price buyers are and when the spread is high, it is called a wide-
willing to pay. spread.

▪ Which type of stocks is more likely to have a wide-

spread?
Type of Orders
• Orders contingent on price:
• Investors also may place orders specifying prices at which they are willing to buy or sell a
security.
• Limit orders:
• A limit buy order may instruct the broker to buy stock or security at or below a stipulated
price.
• A limit sell order instructs the broker to sell the security when the price rises above the
specified limit.
• Stop-loss order: allows a stock to be sold if the price falls below a predetermined level.
Stop-loss orders often accompany short sales.
• Stop-buy order: A stop-buy order is entered at a stop price above the market price to protect
the stock from getting away from you as it rises.
Price-Contingent Orders
Example

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Trading Costs

• Brokerage Commission:

• Explicit cost of trading

• Full service vs. discount brokerage

• Spread:

• Implicit cost of trading

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Computation of Impact cost of trading
• Impact cost represents the cost of executing a transaction in a given stock for a specific
predefined order size at any given point in time.
• Impact cost is a practical and realistic measure of market liquidity; it is closer to the true
cost of execution faced by a trader in comparison to the bid-ask spread.
• It is the percentage markup observed while buying/selling the desired quantity of stock with
reference to its ideal price (best buy + best sell) / 2.
 Market Capitalization of Different Countries

Market Capitalization in 2022 ($ Billions)

45000
40000
35000
30000
25000
20000
15000
10000
5000
0
United China Japan Hong Kong India United Canada Saudi Germany Switzerland
States SAR, China Kingdom Arabia
©2018 McGraw-Hill Education

• Borrowing part of the total purchase price of a

position using a loan from a broker

• Investor contributes the remaining portion

Buying on Margin
(1 of 2) • Margin refers to the percentage or amount
contributed by the investor

• You profit when the stock rises

3-12
Buying on Margin
(2 of 2)

• Initial margin is set by the Fed (SEBI and Stock Exchange in Indian Scenario)
• Currently 50%

• Maintenance margin
• Minimum equity that must be kept in the margin account
• Margin call if value of securities falls too much

©2018 McGraw-Hill Education 3-13

Margin Trading: Initial Conditions
Share price $100
Initial Margin: 60%
Maintenance Margin: 40%
Shares Purchased: 100

Initial Position
Stock $10,000 Borrowed $4,000
Equity $6,000

©2018 McGraw-Hill Education 3-14

 Margin Trading: Margin Call
Stock price falls to $70 per share
New Position
Stock $7,000 Borrowed $4,000
Equity $3,000

Margin% = $3,000/$7,000 = 43%

©2018 McGraw-Hill Education 3-15

 Margin Trading: Maintenance Margin

How far can the stock price fall before a

margin call? Let maintenance margin = 30%
Equity = 100P - $4000

Percentage margin = (100P - $4,000)/100P

(100P - $4,000)/100P = 0.30

Solve to find:

P = $57.14

©2018 McGraw-Hill Education 3-16

Practice Question
• Suppose that Xtel currently is selling at $20 per share. You buy 1000 shares using $15,000 of
your own money, borrowing the remainder of the purchase price from your broker. The rate
on the margin loan is 8%.
• What is the percentage increase in the net worth of your brokerage account if the price of Xtel
immediately changes to : i)$22, ii)$20, iii)$18? What is the relationship between your
percentage return and the percentage change in the price of Xtel?
• If the maintenance margin is 25%, how low can Xtel’s price fall before you get a margin call?
• How would you answer to (b), if you had financed the initial purchase with only $10,000 of
your own money?
• What is the rate of return on your margined position (assuming again that you invested
$15000 of your own money) if Xtel is selling after 1 year at: (i) $22, (ii) $20, (iii) $18? What is
the relationship between your percentage return and the percentage change in the price of
Xtel? Assume that Xtel pays no dividends.
 Short Sales
• Purpose
• To profit from a decline in the price of a stock or security
• Mechanics
• Borrow stock through a dealer
• Sell it and deposit proceeds and margin in an account
• Closing out the position: Buy the stock and return to the party from which
it was borrowed

©2018 McGraw-Hill Education 3-18

Short Sale Mechanics

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 Short Sale: Initial Conditions

Dot Bomb 1000 Shares

Initial Margin 50%
Maintenance Margin 30%
Initial Price $100

Sale Proceeds $100,000

Margin & Equity $50,000
Stock Owed 1000 shares

©2018 McGraw-Hill Education 3-20

 Short Sale:
Dot Bomb falls to $70 per share

Assets Liabilities
$100,000 (sale proceeds) $70,000 (buy shares)
$50,000 (initial margin)
Equity
$80,000

Profit = Ending equity - Beginning equity

= $80,000 - $50,000 = $30,000
= Decline in share price × Number of shares sold short

©2018 McGraw-Hill Education 3-21

 Short Sale: Margin Call
How much can the stock price rise before a margin call?

($150,000* - 1000P)/(1000P) = 30%

P = $115.38

* Initial margin plus sale proceeds

©2018 McGraw-Hill Education 3-22

Practice Question
• Suppose you sell short 1000 shares of Xtel, currently selling for $20 per
share, and give your broker $15000 to establish your margin account.
• A) If you earn no interest on fund in your margin account, what will be your
rate of return after one year if Xtel stock is selling at: i) $22, ii) $20, iii) $18.
• B) If maintenance margin is 25%, how high can Xtel price rise before you get a
margin call?
Introduction to Modern Portfolio Theory
SE SSIO N S 3 & 4
Rate of Return for Different Holding Periods

Holding Period Return:

𝑴𝒂𝒕𝒖𝒓𝒊𝒕𝒚 𝑷𝒓𝒊𝒄𝒆
𝒓𝒇 𝑻 = − 𝟏
𝑷(𝑻)

Effective Annual Rate (EAR): The percentage of return over a 1-year horizon.

𝟏 + 𝑬𝑨𝑹 = [𝟏 + 𝒓𝒇 𝑻 ]𝟏/𝑻 𝑬𝑨𝑹 = [𝟏 + 𝒓𝒇 𝑻 ]𝟏/𝑻 −𝟏

Annual Percentage Rates (APR):Annualized rates on short term investment (T<1) often are reported using
simple rather than compound interest.
𝑨𝑷𝑹 = 𝒏 × 𝒓𝒇 𝑻 (𝟏 + 𝑬𝑨𝑹)𝑻 −𝟏 𝑛 = 1/𝑇
𝑨𝑷𝑹 =
𝑻
n is the compounding periods in a year.
Comparison of returns between Infosys and TCS
Holding
Purchase Maturity
Maturity Price T Period EAR APR APR
Price Period
Return
₹ 1,479.40 ₹ 1,514.45 One week 1/52 2.37% 237.91% 123.20% 123.20%
₹ 1,479.40 ₹ 1,551.05 One month 1/12 4.84% 76.39% 58.12% 58.12%
₹
₹
1,479.40
1,479.40
₹ 1,393.75 One quarter 1/4
1/2
-5.79% -21.22% -23.16% -23.16%
Infosys
₹ 1,524.00 Half year 3.01% 6.12% 6.03% 6.03%
₹ 1,479.40 ₹ 1,333.70 One Year 1 -9.85% -9.85% -9.85% -9.85%
₹ 1,479.40 ₹ 1,590.80 Two Years 2 7.53% 3.70% 3.77% 3.77%

Duration: 1/7/2022 to 1/7/2024

Holding
Purchase Maturity
Maturity Period T Period EAR APR APR
Price Price
Return

TCS ₹ 3,315.10 ₹ 3,265.45 One week 1/52 -1.50% -54.37% -77.88% -77.88%
₹ 3,315.10 ₹ 3,298.80 One month 1/12 -0.49% -5.74% -5.90% -5.90%
₹ 3,315.10 ₹ 2,984.95 One quarter 1/4 -9.96% -34.27% -39.84% -39.84%
₹ 3,315.10 ₹ 3,261.45 Half year 1/2 -1.62% -3.21% -3.24% -3.24%
₹ 3,315.10 ₹ 3,272.30 One Year 1 -1.29% -1.29% -1.29% -1.29%
₹ 3,315.10 ₹ 3,978.20 Two Years 2 20.00% 9.55% 10.00% 10.00%
 Return and Risk
• Holding period returns (HPR) in stock:

𝐸𝑛𝑑𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑎 𝑠𝑡𝑜𝑐𝑘 − 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑎 𝑠𝑡𝑜𝑐𝑘 + 𝐶𝑎𝑠ℎ 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑

𝐻𝑃𝑅 =
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒
Infosys:
1590.80 − 1479.40 + 80
𝐻𝑃𝑅 = = 12.94%
1479.40
TCS:
3978.20 − 3315.10 + 188
𝐻𝑃𝑅 = = 25.67%
3315.10
𝐴𝑛𝑛𝑢𝑎𝑙 𝐻𝑃𝑅 = 𝐻𝑃𝑅1/𝑛
Expected Return:
𝑬 𝒓 = ෍ 𝒑 𝒔 𝒓(𝒔)
𝒔
P(s) is the probability of each scenario and r(s) is the HPR in each scenario
Standard Deviation:
𝝈𝟐 = ෍ 𝒑 𝒔 [𝒓 𝒔 − 𝑬 𝒓 ]𝟐
𝒔
 Excess return and risk premium
• The reward is measured as the difference between the expected HPR of stock and the risk-
free rate. It is also known as the risk premium.
• The difference between the actual rate of return on a risky asset and the actual risk-free rate
is called the excess return.
• The expected value of the excess return (probability adjusted) is the risk premium.
Purchase Price ₹ 100.00 Risk free return 0.04

Squared
Year End Deviation Excess
Scenario Probability Cash Dividend HPR deviation from
Price from mean Return
mean
Excellent 0.25 126.50 4.50 0.3100 0.2124 0.0451 0.2700
Good 0.45 110.00 4.00 0.1400 0.0424 0.0018 0.1000
Poor 0.25 89.75 3.50 -0.0675 -0.1651 0.0273 -0.1075
Crash 0.05 46.00 2.00 -0.5200 -0.6176 0.3815 -0.5600

Expected Return 0.0976

Variance of HPR 0.0380
Standard deviation of HPR 0.1949
Risk Premium 0.0576
Expected return and standard deviation in historical data
• In the case of historical data, each observation is treated equally. Hence, the probability of
each observation is equal, i.e., p(s)=1/n.
Expected Return = Average of the HPR
• Standard deviation is also estimated using equal probability. However, the estimation uses
n/(n-1) to avoid the degree of freedom bias.
Infosys TCS
Year HPR HPR Prob.
1 19.86% 15.32% 0.166667
2 26.24% 7.07% 0.166667
3 70.33% 40.69% 0.166667
4 -1.89% 5.56% 0.166667
5 -10.37% 7.06% 0.166667
6 19.53% 18.27% 0.166667

Average Return 20.62% 15.66%

Expected Return 20.62% 15.66%

Variance 7.94% 1.77%

 Reward to Volatility (Sharpe) Ratio
• The importance of trade-off between reward (risk premium) and risk (standard deviation of
excess return) suggests that we measure the attraction of a portfolio by the ratio of its risk
premium to the standard deviation of its excess return.

Infosys TCS Risk Free Return Infosys TCS

Year HPR HPR Prob. T-Bill (91 Days) Excess Return

1 19.86% 15.32% 0.166667 6.03% 13.83% 9.29%
2 26.24% 7.07% 0.166667 3.19% 23.05% 3.88%
3 70.33% 40.69% 0.166667 3.47% 66.86% 37.22%
4 -1.89% 5.56% 0.166667 5.09% -6.98% 0.47%
5 -10.37% 7.06% 0.166667 6.74% -17.11% 0.32%
6 19.53% 18.27% 0.166667 6.86% 12.67% 11.41%

Average Return 20.62% 15.66% Risk Premium 15.39% 10.43%

Expected Return 20.62% 15.66% Standard Deviation 29.24% 13.89%
Variance 7.94% 1.77%
Standard Deviation 28.18% 13.29% Sharpe Ratio 0.5262 0.7513
Covariance 0.033745
 Portfolios of Two Assets: Expected Return
Consider a Portfolio made up of Equity (stocks) and Debt (bonds)

rp = wD rD + wE rE
where wD = Weightage of investment in Asset D

wE = Weightage of investment in Asset E

rD = Return of Asset D

rE = Return of Asset E

E (rp ) = w D E (rD ) + wE E (rE )

©2018 McGraw-Hill Education 7-8
 Portfolios of Two Assets: Risk

• Portfolio variance:
 = w  + w  + 2wD wE Cov ( rD , rE )
2
p
2
D
2
D
2
E
2
E

•  2
D = Bond variance

•  E2 = Equity variance

• Cov ( rD , rE ) = Covariance of returns for bond and equity

©2018 McGraw-Hill Education 7-9

 Risk and Risk Aversion
(1 of 2)

Speculation Gambling
• Taking considerable risk for a • Bet on an uncertain outcome for
commensurate gain enjoyment
• Parties have heterogeneous • Parties assign the same
expectations probabilities to the possible
outcomes

©2018 McGraw-Hill Education 6-10

 Risk and Risk Aversion
(2 of 2)

• Utility Values
• Investors are willing to consider:
• Risk-free assets
• Speculative positions with positive risk premiums
• Portfolio attractiveness
• Increases with expected return
• Decreases with risk
• What happens when return increases with risk?
• Higher utility values are assigned o portfolios with more attractive risk-return
profiles
1 2
𝑈 = 𝐸 𝑟 − 𝐴𝜎
2

©2018 McGraw-Hill Education 6-11

 Available Risky Portfolios

Each portfolio receives a utility score to assess the investor’s

risk/return trade off

©2018 McGraw-Hill Education 6-12

 Risk Aversion and Utility Values
• Utility Function
• U = Utility
• E(r) = Expected return on the asset or portfolio
• A = Coefficient of risk aversion
• σ2 = Variance of returns
• ½ = A scaling factor

U = E (r ) − 1 A 2
2
©2018 McGraw-Hill Education 6-13
Utility Scores of Portfolios with Varying
Degrees of Risk Aversion

What is the utility score of all three investors for risk free alternatives?

U = E ( r ) − 1 A 2
2
©2018 McGraw-Hill Education 6-14
One minute quiz
• A portfolio has an expected rate of return of 20% and standard deviation of
30%. T-bills offers a safe rate of return of 7%. Would n investor with risk-
aversion parameter A=4 prefer to invest in T-bills or the risky portfolio?
• What if A = 2?
 Investor Types
• Risk Averse Investors:
A0
• Risk-Neutral Investors:
A=0
• Risk Lovers:
A0
Where A = Coefficient of risk aversion

©2018 McGraw-Hill Education 6-16

Trade-Off Between Risk and Return

©2018 McGraw-Hill Education 6-17

Mean-Variance (M-V) Criterion
• Mean-Variance (M-V) Criterion

• Portfolio X dominates portfolio Y if:

E ( rX )  E ( rY )
and
 X  Y
and at least one inequality is strict

©2018 McGraw-Hill Education 6-18

Indifference Curves

Equally preferred
portfolios will lie in the
mean–standard
deviation plane on an
indifference curve,
which connects all
portfolio points with
the same utility value

©2018 McGraw-Hill Education 6-19

Portfolios with same utility values
Risk Aversion (A) = 4

Expected Return Standard Deviation Utility

0.10 0.200 0.10-0.5×4×0.04 = 0.02
0.15 0.255 0.15-0.5×4×0.065 = 0.02
0.20 0.300 0.20-0.5×4×0.09 = 0.02
0.25 0.339 0.25-0.5×4×0.115 = 0.02

U = E (r ) − 1 A 2
2
Capital Allocation to
Assets

The Modern Portfolio Theory

Risk aversion and Utility values
• Risky assets command a risk premium. A portfolio is more attractive when its
expected return is higher, and its risk is lower.
• But when risk increases along with return, the most attractive portfolio is not
obvious.
• How can investors quantify the rate at which they are willing to trade off return
against risk?
• We will assume that each investor can assign a “utility” score to competing
portfolio based on the risk and return profile.
• Portfolio receive higher utility values for higher expected returns and lower
scores for higher volatility.
Risk aversion and Utility values
Utility function:
• U is the utility value U = E ( r ) − 1 A 2
2
• A is an index of the investor’s risk aversion
• The factor of ½ is a scaling conversion Expected Return Risk (SD) Utility Score
0.10 0.15 0.04375
• E(r) is the expected return 0.10 0.2 0
• σ2 is the variance of return (risk) 0.10 0.3 -0.125
A 5
• For A = 2, the utility scores are:
• So, the “utility” score will enhance by higher expected return and reduced by high
risk.
• What is the utility score of a risk-free security?
• U = Return of the Risk-free security
Risk aversion and Utility values
• In the utility function, A is an investor’s risk aversion index. Type A Value
• What will happen to the utility score in case of a higher A? Risk Averse A>0
Risk Neutral A=0
• The higher A score will penalize risky investments more severely.
Risk Lover A<0
• So, more risk-averse investors penalize risky investments more.
• The utility score is linked with the theory of choices under certainty. We can interpret the
utility score of the risky portfolio as a certainty equivalent rate of return.
• The certainty equivalent rate of return is the rate that a risk-free security needs to offer to
provide the same utility score as the risk portfolio provides.
Expected Return Risk (SD) Utility Score Utility Score
• For ex: The utility score of risky portfolio A = 0.07 0.10 0.15 0.0775 0.0325
• So, the T-bill return must be 7% to match the utility score of A. 0.20 0.15 0.1775 0.1325
0.30 0.15 0.2775 0.2325
• Hence, the certainty equivalent rate is 7%.
A 2 6

• A portfolio is attractive when a certainty equivalent rate is higher than a risk-free alternative.
Summary Mean and Standard Deviation
Utility
Risk Aversion
1.20
0.00

Standard Deviation Variance E(r) Premium

• The relationship between expected return, risk and utility 0.000 - 1.2000 -
0.050 0.0025 1.2000 -
0.100 0.0100 1.2000 -
Type Risk E(R) – Utility Curve 0.150 0.0225 1.2000 -
Aversion (ρ) 0.200 0.0400 1.2000 -
Index (A) 0.250 0.0625 1.2000 -

Risk Averse A>0 ρ>0 Concave

Expected Return and Standard Deviation for Constant
Risk Neutral A=0 ρ=0 Linear Utility
1.2200
Risk Lover A<0 ρ<0 Convex
1.2000

Expected Return
1.1800

• The indifference curve will contain all portfolios having 1.1600

same utility value.
1.1400

1.1200

1.1000
0.000 0.050 0.100 0.150 0.200 0.250 0.300
Variance
Capital Allocation Across Risky and Risk-Free Portfolios

• Let's consider that you are investing your money in one risky portfolio and one risk-free asset
to achieve the risk-return trade-off.
Weightage in Weightge in Total
• Asset Allocation: Security Amount
Risky Asset Investment

• Portfolio of one risky and one risk-free asset Risky Portfolio (P) ₹ 2,10,000.00 0.7

Security A ₹ 1,13,400.00 0.54 0.378

0.322
• WP = y (risky portfolio) Security B ₹ 96,600.00 0.46
0.3
• WF = 1-y (risk free asset) Risk Free Security (F) ₹ 90,000.00

Total Investment ₹ 3,00,000.00 1.00

• Return of complete portfolio:
𝑟𝑐 = 𝑦 × 𝑟𝑝 + (1 − 𝑦) × 𝑟𝑓
• Expected return of complete portfolio:

𝐸(𝑟𝑐 ) = 𝑦 × 𝐸(𝑟𝑝 ) + (1 − 𝑦) × 𝑟𝑓
𝜎𝑐 = 𝑦𝜎𝑝
= 𝑟𝑓 + 𝑦[E 𝑟𝑝 − 𝑟𝑓 ]
Example
rf = 7% f = 0%
E(rp) = 15% p = 22%

• The expected return on the complete portfolio:

E ( rc ) = 7 + y  (15 − 7 )
• The risk of the complete portfolio:

 C = y   P = 22  y

©2018 McGraw-Hill Education 6-7

Capital Allocation Line (CAL)
Weightage of Risky Portfolio
(y)
E(rp) SD(P) rf SD (c) E(rc)

0 0.15 0.22 0.07 0.000 0.070

0.1 0.15 0.22 0.07 0.022 0.078
0.2 0.15 0.22 0.07 0.044 0.086
0.3 0.15 0.22 0.07 0.066 0.094
0.4 0.15 0.22 0.07 0.088 0.102
0.5 0.15 0.22 0.07 0.110 0.110
0.6 0.15 0.22 0.07 0.132 0.118
0.7 0.15 0.22 0.07 0.154 0.126
0.8 0.15 0.22 0.07 0.176 0.134
0.9 0.15 0.22 0.07 0.198 0.142
1 0.15 0.22 0.07 0.220 0.150
1.1 0.15 0.22 0.07 0.242 0.158
1.2 0.15 0.22 0.07 0.264 0.166
1.3 0.15 0.22 0.07 0.286 0.174
1.4 0.15 0.22 0.07 0.308 0.182
 Capital Allocation Line (CAL)
Capital Allocation Line
0.200
0.190
0.180 Slope of the CAL
0.170
0.160
0.150 𝐸 𝑟𝑝 − 𝑟𝑓 8
0.140 𝑆𝑙𝑜𝑝𝑒 = =
0.130 𝜎𝑝 22
0.120
Expected Return

0.110
0.100
0.090
0.080
The slope that measure the
0.070 reward to volatility ratio is
0.060 Known as Sharpe Ratio.
0.050
0.040
0.030
0.020
0.010
0.000
0.000 0.020 0.040 0.060 0.080 0.100 0.120 0.140 0.160 0.180 0.200 0.220 0.240 0.260 0.280 0.300 0.320 0.340

Risk
The Investment Opportunity Set

©2018 McGraw-Hill Education 6-10

CAL Equation (from point F to P)
• Let's rewrite the expected return and risk of the complete
portfolio:
𝐸(𝑟𝑐 ) = 𝑟𝑓 + 𝑦[E 𝑟𝑝 − 𝑟𝑓 ]

𝜎𝑐 = 𝑦𝜎𝑝
𝐸 𝑟𝑝 − 𝑟𝑓
𝒚 = 𝝈𝒄 /𝝈𝒑 𝑆𝑙𝑜𝑝𝑒 =
𝜎𝑝
𝜎𝑐
𝐸(𝑟𝑐 ) = 𝑟𝑓 + [E 𝑟𝑝 − 𝑟𝑓 ]
𝜎𝑝

𝐸(𝑟𝑐 ) = 𝑟𝑓 + 𝜎𝑐 × 𝑆𝑙𝑜𝑝𝑒
 Capital Allocation Line (CAL) with borrowed capital
Capital Allocation Line
Weightage of 0.180

Risky Portfolio E(rp) SD(P) rf SD (c) E(rc)

0.160
(y)
0 0.15 0.22 0.07 0.000 0.070 0.140
0.1 0.15 0.22 0.07 0.022 0.078
0.2 0.15 0.22 0.07 0.044 0.086 0.120

0.3 0.15

Expected Return
0.22 0.07 0.066 0.094
0.100
0.4 0.15 0.22 0.07 0.088 0.102
0.5 0.15 0.22 0.07 0.110 0.110 0.080
0.6 0.15 0.22 0.07 0.132 0.118
0.7 0.15 0.22 0.07 0.154 0.126 0.060
0.8 0.15 0.22 0.07 0.176 0.134
0.9 0.15 0.22 0.07 0.198 0.142 0.040

1 0.15 0.22 0.07 0.220 0.150

0.020
1.1 0.15 0.22 0.10 0.242 0.155
1.2 0.15 0.22 0.10 0.264 0.160 0.000
1.3 0.15 0.22 0.10 0.286 0.165 0.000 0.022 0.044 0.066 0.088 0.110 0.132 0.154 0.176 0.198 0.220 0.242 0.264 0.286 0.308

1.4 0.15 0.22 0.10 0.308 0.170 Risk

The capital allocation line will be a kinked one with borrowed capital. Note: Non-government investors borrowing
rate (𝑟𝑓𝐵 ) will exceed the risk-free rate.
𝐸 𝑟𝑝 − 𝑟𝑓𝐵 0.15 − 0.10 5
𝑆𝑙𝑜𝑝𝑒 = = =
The slope at the borrowing range: 𝜎𝑝 0.22 22
Risk Tolerance and Asset Allocation

• Investors choose one optimal complete portfolio from feasible

choices using risk-return trade-off (Capital Allocation Line).

• Expected return of the complete portfolio:

E ( rc ) = rf + y   E ( rp ) − rf 
• Variance:
 = y 
2
c
2 2
p
Utility Levels for Various Positions in Risky Assets

©2018 McGraw-Hill Education 6-14

 Utility
0.100
0.090
0.080
0.070
0.060
A=4 0.050
0.040
0.030
0.020
0.010
0.000
0 0.2 0.4 0.6 0.8 1 1.2
Allocation of Risky Assets

Optimal Position for Risk-Averse Investor 𝐸 𝑟𝑝 − 𝑟𝑓

𝑦∗ =
0.15 − 0.07 𝐴𝜎𝑝2
𝑦∗ = 2
= 0.41
4 ∗ 0.22 A risk-averse investor should invest 41% in risky assets.
Calculations of Indifference Curves

©2018 McGraw-Hill Education 6-16

 Indifference Curves for
U = .05 and U = .09 with A = 2 and A = 4

©2018 McGraw-Hill Education 6-17

Finding the Optimal Complete Portfolio

©2018 McGraw-Hill Education 6-18

Expected Returns on Four Indifference Curves and
the CAL

©2018 McGraw-Hill Education 6-19

Passive Strategies: The Capital Market Line

• The passive strategy avoids security analysis

• Supply/demand forces may make this strategy reasonable for

many investors

• A natural candidate for a passively held risky asset would be the

S&P 500 or Nifty 500

©2018 McGraw-Hill Education 6-20

Passive Strategies: The Capital Market Line

• The Capital Market Line (CML)

• Is a capital allocation line formed investment in two passive portfolios:

1. Virtually risk-free short-term T-bills (or a money market

fund)
2. Fund of common stocks that mimics a broad market index

©2018 McGraw-Hill Education 6-21

Passive Strategies: The Capital Market Line
• Optimal Position for Risk-Averse Investor
𝐸 𝑟𝑀 − 𝑟𝑓 CAL & CML
𝑦∗ = 2 0.200
𝐴𝜎𝑀 0.180
0.160
0.140
0.120

Return
0.100
0.080
0.060
0.040
0.020
0.000
0.000 0.050 0.100 0.150 0.200 0.250 0.300 0.350
Risk

CAL CML

©2018 McGraw-Hill Education 6-22

Optimal Risky
Portfolio
The Investment Decision
• Top-down process with 3 steps:
1. Capital allocation: risky portfolio and risk-free asset
2. Asset allocation: across broad asset classes
3. Security selection: individual assets within asset class

©2018 McGraw-Hill Education 7-24

Diversification and Portfolio Risk
• Market risk
• Marketwide risk sources
• Remains even after diversification
• Also called: Systematic or Nondiversifiable
• Firm-specific risk
• Risk that can be eliminated by diversification
• Also Called: Diversifiable or Nonsystematic

©2018 McGraw-Hill Education 7-25

Portfolio Risk and the Number of Stocks in the Portfolio

Panel A: All risk is firm specific Panel B: Some risk is systematic

©2018 McGraw-Hill Education 7-26

Portfolio Diversification

©2018 McGraw-Hill Education 7-27

Portfolios of Two Risky Assets: Expected Return
Consider a Portfolio made up of Equity (stocks) and Debt (bonds)

rp = wD rD + wE rE

E (rp ) = w D E (rD ) + wE E (rE )

©2018 McGraw-Hill Education 7-28

Portfolios of Two Risky Assets:
Risk
• Portfolio variance:
 = w  + w  + 2wD wE Cov ( rD , rE )
2
p
2
D
2
D
2
E
2
E

•
2
D = Bond variance

•  2
E = Equity variance

• ( rD , rE ) = Covariance of returns for bond and equity

Cov

©2018 McGraw-Hill Education 7-29

Portfolios of Two Risky Assets: Covariance
• Covariance of returns on bond and equity:
Cov(rD , rE ) = rDE D E
• D,E = Correlation coefficient of returns
• D = Standard deviation of bond returns
• E = Standard deviation of equity returns

©2018 McGraw-Hill Education 7-30

Portfolios of Two Risky Assets:
Correlation Coefficients (1 of 2)
• Range of values for 1,2
− 1.0    1.0
• If  = 1.0 → perfectly positively correlated securities
• If  = 0 → the securities are uncorrelated
• If  = - 1.0 → perfectly negatively correlated securities

©2018 McGraw-Hill Education 7-31

Portfolios of Two Risky Assets:
Correlation Coefficients (2 of 2)
• When ρDE = 1, there is no diversification

 P = wE E + wD D
• When ρDE = -1, a perfect hedge is possible

D
wE = = 1 − wD
 D + E

©2018 McGraw-Hill Education 7-32

Portfolios of Two Risky Assets:
Example — 50%/50% Split

Expected Return: E (rp ) = w D E (rD ) + wE E (rE )

= .50  8% + .50 13% = 10.5%
Variance:  p2 = wD2  D2 + wE2 E2 + 2wD wE Cov ( rD , rE )
= .502 122 + .502  202 + 2  .5  .5  72 = 172
 P = 172 = 13.23%
©2018 McGraw-Hill Education 7-33
Portfolio Expected Return

©2018 McGraw-Hill Education 7-34

Computation of Portfolio Variance
from the Covariance Matrix

©2018 McGraw-Hill Education 7-35

Portfolio Standard Deviation

©2018 McGraw-Hill Education 7-36

Portfolio Expected Return as a Function of
Standard Deviation

©2018 McGraw-Hill Education 7-37

 The Minimum Variance Portfolio
• The minimum variance portfolio: the portfolio composed of risky
assets with smallest standard deviation

• Risk reduction depends on the correlation:

• If  = +1.0, no risk reduction is possible
• If  = 0, σP may be less than the standard deviation of either
component asset
• If  = -1.0, a riskless hedge is possible

©2018 McGraw-Hill Education 7-38

The Opportunity Set of the Debt and Equity
Funds and Two Feasible CALs
Portfolio A
E (rA ) = 8.9%
 A = 11.45%

Portfolio B
E (rB ) = 9.5%
 B = 11.70%

©2018 McGraw-Hill Education 7-39

The Sharpe Ratio
• Maximize the slope of the CAL for any possible portfolio, P
• The objective function is the slope:

E (rp ) − rf
Sp =
p

©2018 McGraw-Hill Education 7-40

The Sharpe Ratio:
Example Portfolio A
E (rA ) = 8.9%
 A = 11.45%
E ( rA ) − rf 8.9% − 5%
SA = = = .34
A 11.45%
Portfolio B
E (rB ) = 9.5%
 B = 11.70%
E ( rB ) − rf 9.5% − 5%
SB = = = .38
B 11.70%
©2018 McGraw-Hill Education 7-41
Debt and Equity Funds with the Optimal Risky
Portfolio
Optimal Risky Portfolio
E (rP ) = 11%
 P = 14.2%
E ( rP ) − rf
SP =
P
11% − 5%
=
14.2%
= .42

©2018 McGraw-Hill Education 7-42

Determination of the Optimal Overall Portfolio

Optimal Allocation to P
A=4
E ( rP ) − rf
y=
A P2
11% − 5%
= = .7439
4  (14.2%) 2

©2018 McGraw-Hill Education 7-43