PORTFOLIO:

A portfolio is a collection of securities since it is really desirable to invest the entire funds of an
individual or an institution or a single security, it is essential that every security be viewed in a
portfolio context. Thus it seems logical that the expected return of the portfolio. Portfolio
analysis considers the determination of future risk and return in holding various blends of
individual securities.

Portfolio expected return is a weighted average of the expected return of the individual
securities.But portfolio variance, in short contrast, can be somewhat reduced because portfolio
risk is because risk depends greatly on the covariance among returns of individual securities.
Portfolios, which are combinations of securities, may or may not take on the aggregate
characteristics of their individual parts.

Since portfolio expected return is a weighted average of the expected return of its securities, the
contribution of each security the portfolio’s expected returns depends on its expected returns and
its proportionate share of the initial portfolio’s market value. It follows that an investor who
simply wants the greatest possible expected return should hold one security, the one which is
considered to have the greatest expected return. Very few investors do this, and very few
investment advisors would counsel such and extreme policy instead, investors should
diversify,meaning that their portfolio should include more than one security

OBJECTIVES OF PORTFOLIO MANAGEMENT:

The main objective of investment portfolio management is to maximize the returns from the
investment and to minimize the risk involved. Moreover, risk in price or inflation erodes the
values of money and hence investment must provide a protection against inflation
.
Secondary objectives:

The following are the other ancillary objectives:

● Regular return.
● Stable income.
● Appreciation of capital.
● More liquidity
● .Safety of investment.
● Tax benefits.

Portfolio management services helps investors to make a wise choice between alternative
investment with pit any post trading hassle’s this service renders optimum returns to the investors
by proper selection of continuous changes of one plan to another plane with in the same
scheme,any portfolio management must specify the objectives like maximum returns, and risk
capital appreciation, safety etc in their offer
NEED FOR PORTFOLIO MANAGEMENT:

Portfolio management is a process encompassing many activities of investment in assets and

securities. It is a dynamic and flexible concept and involves regular and systematic analysis,
judgment and action.
The objective of this service is to help the unknown and investors with the
expertise of professionals in investment portfolio management. It involves construction of a
portfolio based upon the investors objectives, constraints, preferences for risk and return and tax
liability.
The portfolio is reviewed and adjusted from time to time in tune with the market conditions.The
evaluation of the portfolio is to be done in terms of targets set for risk and returns. The changes
in the portfolio are to be effected to meet the changing condition.Portfolio construction refers to
the action of surplus funds in hand among a variety of financial assets open for investment.
Portfolio theory concerns itself with the principles governing such allocation. The modern view
of investment is oriented more towards the assembly of proper combinations of individual
securities to form an investment portfolio. A Combination of securities held together will give
beneficial results if they are grouped in a manner to secure higher returns after taking into
consideration the risk elements.
The modern theory is the view that by diversification risk can be reduced. Diversification can be
made by the investor either by having a ge number of shares of companies in different regions,
indifferent industries or those producing different types of product lines.Modern theory believes
the perspective of combination of securities under constraints of risk and returns

PORTFOLIO MANAGEMENT PROCESS:

Investment management is a complex activity which may be broken down into the following
steps:

Specification of investment objectives and constraints:

The typical objectives sought by investors are currents income, capital appreciation,
and safety of principle. The relative importance of these objectives should be specified
further the constraints arising from liquidity, time horizon, tax and special circumstances
must be identified.

Choice of the Asset mix:

The most important decision in portfolio management is the asset mix decision very
broadly; this is concerned with the proportion of stock (equity shares and units/ shares of
equity oriented mutual funds) and µbonds in the portfolio.
The appropriate µstock-bond mix depends mainly on the risk tolerance and investment
horizon of the investor
Risk:

Risk is uncertainty of the income / capital appreciations or loss or both. All

investments are risky. The higher the risk taken, the higher is the return. But proper
Management of risk involves the right choices of investments whose risks are compensating.

The two major types of risks are:

Systematic or market related risk.

Unsystematic or company related risks.

Systematic risks

Systematic risks affected from the entire market are (the problems, raw material
availability, tax policy or government policy, inflation risk, interest risk and financial risk
). It is managed by the use of Beta Of different company shares

Unsystematic risks

Unsystematic risks are mismanagement, increasing inventory,

wrong financial policy, defective marketing. This is diversifiable or avoidable because it is
possible to eliminate or diversify away these components of risks to a considerable extent
by investing in a large portfolio of securities. The unsystematic risk stems from inefficiency
magnitudes of those factors different from one company to another.

RETURNS ON PORTFOLIO:

Each security in portfolio contributes returns in the proportion of its investments in

security. Thus the portfolio expected return is the weighted average of the expected return, from
each of the securities, with weights representing the proportions share of the security in the total
investment.
Why does an investor have so many securities in his portfolio?
If the ABC gives the maximum return why not he invests in that security all his funds and thus
maximize return? The Answer to this questions lie in the investors perception of risk attached to
investments, his objectives of income, safety,appreciation, liquidity
and hedge against loss of value of money etc. this pattern of investment in different asset
categories, types of investment, etc, would all be described under the caption of diversification,
which aims at the reduction or even elimination of non-systematic risks and achieve the specific
objectives of investors

RISK ON PORTFOLIO:

The expected returns from individual securities c

carry some degree of risk.Risk on the portfolio is different from the risk on individual securities.
The risk is reflected in the variability of the returns from zero to infinity.Risk of the individual
assets or portfolios measured by the variance of its returns.The expected return depends on the
probability of the returns and their weighted contribution to the risk of the portfolio

What is an efficient Frontier?

For Markowitz portfolio theory checkout

Markowitz portfolio theory, Markowitz’s Theory, MPT, Investment Analysis and Portfolio …

For CAPM & Assumptions of CAPM follow this:

CAPM Model, Capital Asset Pricing Model, CAPM Problems, CAPM Numerical, capm b…

Capital Asset Pricing Model: Pricing and Assumptions - Meaning, Assumption, Formula | …

For Single Index Model/Sharpe Ratio follow this:

Sharpe measure, Sharpe ratio, Performance Evaluation of existing portfolio, investment an…

What Is an Expected Return? (Single Asset Investment)

● The expected return is the amount of profit or loss an investor can anticipate receiving on
an investment.
● An expected return is calculated by multiplying potential outcomes by the odds of them
occurring and then totaling these results.
● Expected returns cannot be guaranteed.
 ● The expected return for a portfolio containing multiple investments is the weighted
average of the expected return of each of the investments
Expected Return = Σ (Returni x Probabilityi)
NOTE:The Probability should be equal to 1

What is the expected return of a portfolio?

An expected return of a portfolio is the weighted average rate of return for all the assets in the
portfolio. The weights represent the proportion invested in each asset in the entire investment
portfolio and can be found by simply multiplying each asset's rate of return with its
corresponding percentage.
What is the Formula of Expected Return of a Portfolio?

Expected Rate of Return (ERR) = (R1 x W1) + (R2 x W2) .. (Rn x Wn)
Where R is the rate of return and W is the asset weight.
What Is Portfolio Variance?

● Portfolio variance is a measure of a portfolio’s overall risk and is the portfolio’s standard
deviation squared.
● Portfolio variance takes into account the weights and variances of each asset in a
portfolio as well as their co-variances.
● A lower correlation between securities in a portfolio results in a lower portfolio variance.
● Portfolio variance (and standard deviation) define the risk-axis of the efficient frontier in
modern portfolio theory (MPT).

The formula for portfolio variance in a two-asset portfolio is as follows:

● Portfolio variance = w12σ12 + w22σ22 + 2w1w2Cov1,2

Where:

● w1 = the portfolio weight of the first asset

● w2 = the portfolio weight of the second asset
● σ1 = the standard deviation of the first asset
● σ2 = the standard deviation of the second asset
 ● Cov1,2 = the co-variance of the two assets, which can thus be expressed as p(1,2)σ1σ2, where
p(1,2) is the correlation co-efficient between the two assets

The portfolio variance is equivalent to the portfolio standard deviation squared.

How Do I Calculate the Standard Deviation of a Portfolio?

σ = (w12σ12 + w22σ22 + 2w1w2Cov1,2)1/2

where: wn is the portfolio weight of either asset, σn2 its variance, and Cov1,2, the covariance
between the two assets.

Module 1

# Expected Return on Single Asset

Question: A stock has a 30% chance of providing a 15% return and a 70% chance of a 5% return.
What is the expected return?
Solution:

(0.30×0.15)+(0.70×0.05)=0.045+0.035=0.08

​ (0.30×0.15)+(0.70×0.05)=0.045+0.035=0.08 or 8%.

Question: An investment has a 60% chance of yielding a 10% return and a 40% chance of a 3%
return. Calculate the expected return.

Solution:

(0.60×0.10)+(0.40×0.03)=0.06+0.012=0.072

​ (0.60×0.10)+(0.40×0.03)=0.06+0.012=0.072 or 7.2%.

Question: A bond has a 20% chance of a 2% return and an 80% chance of a 5% return.
Determine the expected return.

Solution:

(0.20×0.02)+(0.80×0.05)=0.004+0.04=0.044

​ (0.20×0.02)+(0.80×0.05)=0.004+0.04=0.044 or 4.4%.
​

Question: Stock A has a 40% probability of a 12% return, and Stock B has a 60% probability of
a 8% return. Find the expected return of a portfolio with equal investments in A and B.

Solution:

(0.40×0.12)+(0.60×0.08)=0.048+0.048=0.096

​ (0.40×0.12)+(0.60×0.08)=0.048+0.048=0.096 or 9.6%.

Question: An investment has a 25% chance of a 5% return and a 75% chance of a 10% return.
Calculate the expected return.

Solution:
 (0.25×0.05)+(0.75×0.10)=0.0125+0.075=0.0875

​ (0.25×0.05)+(0.75×0.10)=0.0125+0.075=0.0875 or 8.75%.

Question: Bond X has a 30% chance of a 3% return, and Bond Y has a 70% chance of a 6%
return. Determine the expected return of a portfolio with 60% in X and 40% in Y

Solution:

(0.60×0.30×0.03)+(0.40×0.70×0.06)=0.0054+0.0168=0.0222

​ (0.60×0.30×0.03)+(0.40×0.70×0.06)=0.0054+0.0168=0.0222 or 2.22%.

Question: A mutual fund has a 15% probability of a 20% return, a 30% probability of a 10%
return, and a 55% probability of a 5% return. Calculate the expected return.

Solution:

​ (0.15×0.20)+(0.30×0.10)+(0.55×0.05)=0.03+0.03+0.0275=0.0875
​
​ (0.15×0.20)+(0.30×0.10)+(0.55×0.05)=0.03+0.03+0.0275=0.0875 or 8.75%.

Question: Asset A has a 25% chance of a 15% return, and Asset B has a 75% chance of a 5%
return. Determine the expected return of a portfolio with 40% in A and 60% in B

Solution:

(0.40×0.25×0.15)+(0.60×0.75×0.05)=0.015+0.0225=0.0375

​ (0.40×0.25×0.15)+(0.60×0.75×0.05)=0.015+0.0225=0.0375 or 3.75%.

Question: A stock has a 10% probability of a 25% return, a 50% probability of a 15% return, and
a 40% probability of a 5% return. Find the expected return.

Solution:

(0.10×0.25)+(0.50×0.15)+(0.40×0.05)=0.025+0.075+0.02=0.12
 ​ (0.10×0.25)+(0.50×0.15)+(0.40×0.05)=0.025+0.075+0.02=0.12 or 12%.

# Expected Return & Risk on Portfolio

Question:
You have a portfolio with two securities, A and B. The weights are 40% for A and 60% for B. If
the standard deviation of A is 10% and B is 15%, calculate the portfolio standard deviation.

Question:
Calculate the portfolio variance for a three-asset portfolio with weights 30%, 40%, and 30% for
assets A, B, and C, respectively. The standard deviations are 12%, 15%, and 10%, and the
correlation coefficients are 0.5 (A-B), 0.7 (A-C), and 0.6 (B-C).

Question:
Given a portfolio with weights 25% in Asset A, 40% in Asset B, and 35% in Asset C. If the
standard deviations of A, B, and C are 18%, 22%, and 15% respectively, and the correlation
coefficients are 0.6 (A-B), 0.5 (A-C), and 0.7 (B-C), calculate the portfolio standard deviation.
Solution:

Question:

For a four-asset portfolio with weights 20%, 25%, 30%, and 25% for assets A, B, C, and D,
respectively. The standard deviations are 12%, 18%, 15%, and 10%, and the correlation
coefficients are 0.4 (A-B), 0.6 (A-C), 0.7 (A-D), 0.5 (B-C), 0.8 (B-D), and 0.6 (C-D). Calculate
the portfolio variance.

Question:
A portfolio consists of three assets, X, Y, and Z, with weights 30%, 45%, and 25%, respectively.
If the standard deviations of X, Y, and Z are 15%, 20%, and 18%, and the correlation coefficients
are 0.6 (X-Y), 0.4 (X-Z), and 0.7 (Y-Z), calculate the portfolio standard deviation.

Question:
You have a five-asset portfolio with weights 15%, 20%, 25%, 15%, and 25% for assets A, B, C,
D, and E. The standard deviations are 10%, 12%, 18%, 15%, and 20%, and the correlation
coefficients are 0.5 (A-B), 0.7 (A-C), 0.4 (A-D), 0.6 (A-E), 0.8 (B-C), 0.3 (B-D), 0.6 (B-E), 0.7
(C-D), 0.5 (C-E), and 0.4 (D-E). Calculate the portfolio variance and standard deviation

#Single Index Model/Sharpe Ratio

1.Our desired investment is the stock of ABC Corp Plc. The stock has returned an average of
15% annually over the past five years.The risk-free investment is the UK Treasury Bill which
has an interest rate of 0.4%.The standard deviation (volatility) of ABC Plc is put at 20%.

Ans:The Sharpe Ratio calculation = (15% - 0.3%) / 20%= 0.73.

Question:
Expected return: 8%
Risk-free rate: 2%
Standard deviation: 12% Calculate the Sharpe ratio.

Solution: Sharpe Ratio=Expected Return−Risk-Free RateStandard DeviationSharpe

Ratio=Standard DeviationExpected Return−Risk-Free Rate Sharpe
Ratio=8%−2%12%=0.060.12=0.5Sharpe Ratio=12%8%−2%=0.120.06=0.5

Question:
Expected return: 10%
Risk-free rate: 3%
Standard deviation: 15% Calculate the Sharpe ratio.

Solution: Sharpe Ratio=Expected Return−Risk-Free RateStandard DeviationSharpe

Ratio=Standard DeviationExpected Return−Risk-Free Rate Sharpe
Ratio=10%−3%15%=0.070.15=0.47Sharpe Ratio=15%10%−3%=0.150.07=0.47

Question:
Expected return: 12%
Risk-free rate: 4%
Standard deviation: 20% Calculate the Sharpe ratio.

Solution: Sharpe Ratio=Expected Return−Risk-Free RateStandard DeviationSharpe

Ratio=Standard DeviationExpected Return−Risk-Free Rate Sharpe
Ratio=12%−4%20%=0.080.20=0.4Sharpe Ratio=20%12%−4%=0.200.08=0.4

Question:
Expected return: 15%
Risk-free rate: 5%
Standard deviation: 18% Calculate the Sharpe ratio.
Solution: Sharpe Ratio=Expected Return−Risk-Free RateStandard DeviationSharpe
Ratio=Standard DeviationExpected Return−Risk-Free Rate Sharpe
Ratio=15%−5%18%=0.100.18=0.56Sharpe Ratio=18%15%−5%=0.180.10=0.56

Question:
Expected return: 18%
Risk-free rate: 6%
Standard deviation: 25% Calculate the Sharpe ratio.

Solution: Sharpe Ratio=Expected Return−Risk-Free RateStandard DeviationSharpe

Ratio=Standard DeviationExpected Return−Risk-Free Rate Sharpe
Ratio=18%−6%25%=0.120.25=0.48Sharpe Ratio=25%18%−6%=0.250.12=0.48

Question:
Expected return: 20%
Risk-free rate: 7%
Standard deviation: 22% Calculate the Sharpe ratio.

Solution: Sharpe Ratio=Expected Return−Risk-Free RateStandard DeviationSharpe

Ratio=Standard DeviationExpected Return−Risk-Free Rate Sharpe
Ratio=20%−7%22%=0.130.22=0.59Sharpe Ratio=22%20%−7%=0.220.13=0.59

#CAPM

Question:
Suppose the risk-free rate is 3%, the expected market return is 8%, and the beta of a particular
stock is 1.5. Calculate the expected return on the stock using the Capital Asset Pricing Model
(CAPM).

Ans: CAPM is 10.5%.

Question

● Risk-Free Rate (RF): 3%

● Beta (β) of the stock: 1.5
● Expected Market Return (RM): 10%
Ans: expected return is 13.5%.

Question

● Risk-Free Rate (RF): 4%

● Beta (β) of the stock: 0.8
● Expected Market Return (RM): 12%

Calculate the Expected Return (RE) using CAPM.

Ans: the expected return is 10.4%

Question

● Risk-Free Rate (RF) = 3%

● Beta (β) = 1.2
● Market Return (RM) = 8%

Ans: 9.6%

Question

● Risk-Free Rate (RF) = 2.5%

● Beta (β) = 0.8
● Market Return (RM) = 7.5%

Ans:8.5%

Question:

Risk-Free Rate (RF) = 4%

Beta (β) = 1.5

Market Return (RM) = 10%

Ans:19%

#APT(Arbitrage Pricing theory)

Question:
Suppose an asset is priced according to the APT model with three factors: inflation rate, interest
rate, and GDP growth. The factor sensitivities (betas) for the asset are 0.8, 1.2, and 0.5,
respectively. If the expected returns on the three factors are 4%, 5%, and 3%, what is the
expected return on the asset?

Question:
If a stock has factor sensitivities of 0.7 ,0.7 and 1.2,1.2 for two factors, and the risk premiums
for these factors are 0.5,0.5 and 0.8,0.8, what is the expected return of the stock according to
APT?

Question:

Consider an asset with sensitivities to three factors, and the risk-free rate is 3%. If the factor risk
premiums are 2%, 1.5%, and 1%, and the asset's sensitivities are 0.8, 1.2, and -0.5 respectively,
calculate the expected return.

Question:
Consider the multifactor APT with two factors. Stock A has an expected return of 17.6%, a
beta of 1.45 on factor 1 and a beta of .86 on factor 2. The risk premium on the factor 1
portfolio is 3.2%. The risk-free rate of return is 5%. What is the risk-premium on factor 2 if
no arbitrage opportunities exit?