6 SEM TDC DSE COM (CBCS)
601 (GR-I)
2023 (May / June)
COMMERCE (Discipline
Specific Elective)
(For Honours and
Non-Honours)
Paper: DSE-601 (Gr-I)
(Security Analysis and
Portfolio Management)
Full
Marks: 80
Pass Marks: 32
Time: 3 hours
The figures in the margin
indicate full marks for the questions
1. (a) State whether the
following statements are True or False: 1x4=4
(1) Treasury bill is a money market security.
Ans: True
(2) Unsystematic risks arise due to inflation.
Ans: False, Unsystematic risks arise due to controllable factors
such as no proper asset allocation.
(3) Personal income tax is assumed to be nil in Capital Asset
Pricing Model.
Ans: True
(4) Jensen’s model is based on Capital Asset Pricing Model.
Ans: True
(b) Fill in the blanks with appropriate word(s): 1x4=4
(1) ______ is a combination of securities.
Ans: Portfolio
(2) Opportunistic building model is also known as ______.
Ans: Sectorial Analysis
(3) Systematic risk can be managed by the use of ______ different
companies.
Ans: Diversification in
(4) A benchmark portfolio represents the ______ evaluation standard.
Ans: Comparison/Standard
2. Write short notes on
(any four): 4x4=16
(a) Investment philosophy.
Investment
refers to the concept of deferred consumption, which involves purchasing
an asset, giving a loan or keeping funds in a bank account with the aim of
generating future returns. Various investment options are available, offering
differing risk-reward tradeoffs. An understanding of the core concepts and a
thorough analysis of the options can help an investor create a portfolio that
maximizes returns while minimizing risk exposure.
Investment
philosophy, also known as investment style,
is a fund manager’s or investor’s particular approach to investing. Some may
focus on companies with promising earnings prospects, seek out underpriced
stocks, or businesses that produce things that are in strong demand.
It is a coherent
way of thinking about markets, how they operate, and the types of mistakes that
the person believes are common features of investor behaviour.
Investment
strategy is much narrower than investment behaviour. When we put our investment
philosophy into practice, that is our investment strategy. When a strategy is
no longer effective, we go back to our investment philosophy to generate a new
one.
(b) Intrinsic value.
Ans: The actual value of a security, as opposed to
its market price or book value is called intrinsic value. The intrinsic value
includes other variables such as brand name, trademarks, and copyrights that
are often difficult to calculate and sometimes not accurately reflected in the
market price. One way to look at it is that the market capitalization is the
price (i.e. what investors are willing to pay for the company and intrinsic
value is the value (i.e. what the company is really worth).
Fundamental
analysis is used to determine the intrinsic value of the share of a company to
find out whether it is overpriced or underpriced by examining the underlying
forces that affect the well-being of the economy, Industry groups and
companies.
(c) Portfolio Management
Scheme.
Ans: Portfolio management is a dynamic concept and requires
continuous and systematic analysis, judgement and operations. It is a process
involving many activities of investment in assets and securities. Firstly, it
involves construction of a portfolio based upon the data base of the
client/investor, his objectives, constraint preferences for risk and return
etc. On the basis of above mentioned facts, selection of assets and securities
is made. Secondly, it involves monitoring/reviewing of the portfolio from time
to time in light of changing market conditions. Accordingly, changes are
effected in the portfolio. Thirdly, it involves evaluation of the portfolio in
terms of targets set for risk and return and making adjustments accordingly.
Portfolio Management scheme (PMS) is a professional financial
service where skilled portfolio managers and stock market professionals manage
your equity portfolio with the assistance of a research team. Many investors
have equity portfolios in their Demat Account but managing them can
be a challenge. PMS is a systematic approach to maximise returns while
minimising the risk factor on your investments. It enables you to make sound
decisions that are supported by extensive research and factual data without
lifting a finger. Additionally, it better prepares you to deal with market
adversity.
(d) Practical application of Arbitrage.
Ans:
(e) Risk and return
measurement.
Ans: Risk may be
described as variability/fluctuation/deviation of actual return from expected
return from a given asset/investment. Higher the variability, greater is the
risk. In other words, the more certain the return from an asset, lesser is the
variability and thereby lesser is the risk. Beta and standard deviation are
measures by which a portfolio or fund's level of risk is calculated.
Standard deviation:
Standard deviation is a statistical measurement that looks at historical
volatility, indicating the tendency of the returns to rise or fall considerably
in a short period of time. A volatile investment has a higher risk because its
performance may change rapidly in either direction at any moment. A higher
standard deviation means an investment is highly volatile, riskier and tends to
yield higher returns. A lower standard deviation means the investment is more
consistent and moves less choppily. It tends to yield more modest returns and
presents a lower risk.
Beta: Beta
attempts to measure an investment's sensitivity to market movements. A high
beta means that an investment is highly volatile and that it will likely
outperform its benchmark in up markets, thus exceeding the benchmark's return,
and underperform it in down markets. A lower beta means an investment is likely
to underperform its benchmark in up markets, but is likely to do better when
the markets fall.
Measurement of return
Return
can be defined as the actual income from a project as well as appreciation in
the value of capital. Thus there are two components in return—the basic
component or the periodic cash flows from the investment, either in the form of
interest or dividends; and the change in the price of the asset, commonly
called as the capital gain or loss.
It
is measured as: Total Return = Cash payments received + Price
change in assets over the period /Purchase price of the asset. In connection
with return we use two terms—realized return and expected or predicted return.
Realized return is the return that was earned by the firm, so it is historic.
Expected or predicted return is the return the firm anticipates to earn from an
asset over some future period.
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3. (a) State the economic
and financial meaning of investment. Discuss the factors that differentiate the
investor from speculator and gambler. 7+7=14
Ans:
Or
(b) What do you understand
by company analysis? Explain the tools available for company analysis. 4+10=14
Ans: COMPANY OR CORPORATE ANALYSIS: This
type of fundamental analysis looks at a specific company, including its
financial statements, management quality, and business model. This analysis
helps to identify the strengths and weaknesses of a company and how they may
impact its performance. This includes analyzing the company's balance sheet,
income statement, cash flow statement and also looking at the company's
management team, their strategy, and the company's competitive positioning.
Tools and
Techniques of corporate Analysis
Financial statement means a statement or document which explains
necessary financial information. Financial statements express the financial
position of a business at the end of accounting period (Balance Sheet) and
result of its operations performed during the year (Profit and Loss Account).
In order to determine whether the financial or operational performance of
company is satisfactory or not, the financial data are analyzed. Different
methods are used for this purpose. The main techniques of financial analysis
are:
The most
commonly used techniques of financial analysis are as follows:
1. Comparative
Statements: These are the statements showing the
profitability and financial position of a firm for different periods of time in
a comparative form to give an idea about the position of two or more periods.
It usually applies to the two important financial statements, namely, balance
sheet and statement of profit and loss prepared in a comparative form. The
financial data will be comparative only when same accounting principles are
used in preparing these statements. If this is not the case, the deviation in
the use of accounting principles should be mentioned as a footnote. Comparative
figures indicate the trend and direction of financial position and operating
results. This analysis is also known as ‘horizontal analysis’.
Merits of
Comparative Financial Statements:
a)
Comparison of financial statements
helps to identify the size and direction of changes in financial position of an
enterprise.
b)
These statements help to ascertain the
weakness and soundness about liquidity, profitability and solvency of an
enterprise.
c)
These statements help the management
in making forecasts for the future.
Demerits
of Comparative Financial Statements:
a)
Inter-firm comparison may be
misleading if the firms are not of the same age and size, follow different
accounting policies.
b)
Inter-period comparison will also be
misleading if there are frequent changes in accounting policies.
2. Common Size
Statements: These are the statements which
indicate the relationship of different items of a financial statement with a
common item by expressing each item as a percentage of that common item. The
percentage thus calculated can be easily compared with the results of corresponding
percentages of the previous year or of some other firms, as the numbers are
brought to common base. Such statements also allow an analyst to compare the
operating and financing characteristics of two companies of different sizes in
the same industry. Thus, common size statements are useful, both, in intra-firm
comparisons over different years and also in making inter-firm comparisons for
the same year or for several years. This analysis is also known as ‘Vertical
analysis’.
Merits of
Common Size Statements:
a)
A common size statement facilitates
both types of analysis, horizontal as well as vertical. It allows both
comparisons across the years and also each individual item as shown in
financial statements.
b)
Comparison of the performance and
financial condition in respect of different units of the same industry can also
be done.
c)
These statements help the management
in making forecasts for the future.
Demerits
of Common Size Statements:
a)
If there is no identical head of
accounts, then inter-firm comparison will be difficult.
b)
Inter-firm comparison may be
misleading if the firms are not of the same age and size, follow different
accounting policies.
c)
Inter-period comparison will also be
misleading if there are frequent changes in accounting policies.
3. Trend Analysis: It
is a technique of studying the operational results and financial position over
a series of years. Using the previous years’ data of a business enterprise,
trend analysis can be done to observe the percentage changes over time in the
selected data. The trend percentage is the percentage relationship, in which
each item of different years bears to the same item in the base year. Trend
analysis is important because, with its long run view, it may point to basic
changes in the nature of the business. By looking at a trend in a particular
ratio, one may find whether the ratio is falling, rising or remaining
relatively constant. From this observation, a problem is detected or the sign
of good or poor management is detected.
Merits of
Trend analysis:
a)
Trend percentages can be presented in
the form of Index Numbers showing relative change in the financial statements
during a certain period.
b)
Trend analysis will exhibit the
direction to which the concern is proceeding.
c)
The trend ratio may be compared with
the industry, in order to know the strong or weak points of a concern.
Demerits
of Common Size Statements:
a) These
are calculated only for major items instead of calculating for all items in the
financial statements.
b)
Trend values will also be misleading
if there are frequent changes in accounting policies.
4. Ratio Analysis: It
describes the significant relationship which exists between various items of a
balance sheet and a statement of profit and loss of a firm. As a technique of
financial analysis, accounting ratios measure the comparative significance of
the individual items of the income and position statements. It is possible to
assess the profitability, solvency and efficiency of an enterprise through the
technique of ratio analysis.
5. Funds
flow statement: The financial
statement of the business indicates assets, liabilities and capital on
a particular date and also the profit or loss during a period. But it is
possible that there is enough profit in the business and the financial position
is also good and still there may be deficiency of cash or of working capital in
business. Financial statements are not helpful in analysing such situation.
Therefore, a statement of the sources and applications of funds is prepared
which indicates the utilisation of working capital during an accounting period.
This statement is called Funds Flow statement.
6. Cash Flow Analysis: A
Cash Flow Statement is similar to the Funds Flow Statement, but while preparing
funds flow statement all the current assets and current liabilities are taken
into consideration. But in a cash flow statement only sources and applications
of cash are taken into consideration, even liquid asset like Debtors and Bills
Receivables are ignored. A Cash Flow Statement is a statement, which summarises
the resources of cash available to finance the activities of a business
enterprise and the uses for which such resources have been used during a
particular period of time. Any transaction, which increases the amount of cash,
is a source of cash and any transaction, which decreases the amount of cash, is
an application of cash. Simply, Cash Flow is a statement which analyses the
reasons for changes in balance of cash in hand and at bank between two
accounting period. It shows the inflows and outflows of cash.
4. (a) Do you think that
the effect of combining securities can bring about a balanced portfolio?
Discuss. 14
Ans: Effects of combining two
securities
It is believed that holding two securities is less risky than
having only one investment in a person’s portfolio. When two stocks are taken
on a portfolio and if they have negative correlation, then risk can be
completely reduced because the gain on one can offset the loss on the other.
The effect of two securities can also be studied when one security
is riskier when compared to the other security. As per Markowitz, given
the return, risk can be reduced by diversification of investment into a number
of securities. The risk of any two securities is different from the risk of a
group of two companies together. Thus, it is possible to reduce the risk of a
portfolio by incorporating into it a security whose risk is greater than that
of any of scrips held initially.
DIVERSIFICATION OF INVESTMENTS
Diversification: Risks involved in investment and portfolio
management can be reduced through a technique called diversification. Diversification is a strategy of investing in a variety of
securities in order to lower the risk involved with putting money into few
investments. The traditional belief is that diversification means “Not
putting all eggs in one basket.” Diversification helps in the reduction of
unsystematic risk and promotes the optimization of returns for a given level of
risks in portfolio management.
Diversification may take
any of the following forms:
a)
Different Assets e.g. gold, bullion,
real estate, government securities etc.
b)
Different Instruments E.g. Shares,
Debentures, Bonds, etc.
c)
Different Industries E.g. Textiles,
IT, Pharmaceuticals, etc.
d)
Different Companies e.g. new
companies, new product company’s etc.
Proper diversification involves two or more companies/industries
whose fortunes fluctuate independent of one another or in different directions.
One single company/industry is always riskier than two companies/industries.
Two company’s in textile industry are riskier than one company in textile and
one in IT sector two companies/industries which are similar in nature of demand
a market is riskier than two in dissimilar industries.
Importance of Diversification in Portfolio Management
Diversification of investments is significant due to the following
reasons:
1. Reduce
the risk: Every stock or financial
instrument carries some amount of risk with it except the risk-free
investments. With portfolio diversification, one cannot completely remove the
risks but can reduce the risk to a great extent. Without proper diversification
amongst the different classes of the assets, the risk of investment rises with
every investment we make. One needs to include both risky asset classes such
as high- return generating stocks and to hedge their risk they should
invest in fixed income assets. Diversification gradually reduces the risk of
the portfolio over time.
2. Helps
in Hedging: If investments are entirely made in stock
market, then in case of excessive volatility the return on investments will
dropped significantly. However, if they investors kept a certain amount of
other investment assets like commodities, bonds, metals in their portfolio,
their profits would have been higher because loss or low profits of the stock
market would have been wiped off by the positive returns of the commodities
market. Diversification helps in achieving desired or better returns even when
the market is slow as there are other markets which make up for the negative or
low yields of the former market. This way investors can hedge their investments
and earn potential returns through portfolio diversification.
3. Provide Higher Returns: Since the market keeps on changing,
we need to diversify with asset classes which are not correlated. Correlation
plays the most critical role in determining returns. If we are investing in one
market which is connected to the other, when the former goes down, that will
substantially affect the other. We need to choose investment vehicles which are
entirely different from each other. That’s why we need a diversified portfolio.
4.
Aligning Portfolio with Financial Aspirations: As per the
Behavioural portfolio theory, either our investment will give us the potential
for high-growth, or it will protect from negative returns. This theory states
that when a portfolio is diversified, it corresponds to a pyramid structure. A
properly diversified portfolio has the maximum of low-risk investments and
provides value growth and steady income generation. ‘Blend’ funds comprise the
top of this pyramid which is a mix of risky and low-risk investment
instruments. The regular income generating investments will provide with periodic
income, and the blend funds will grow in value, and together they bring
stability of investment and higher wealth accumulation.
5.
Investment Mix Adjustment: Portfolio diversification allows us to
modify investment mix as per changing financial needs and market changes. With
age, the investment mix also needs to be changed as the tenure for investments
keeps on reducing. While we start off with high-risk investment instruments,
with time flowing, we must reduce our risk by shifting more towards fixed
income financial instruments for regular earnings. While an investor of 20’s
age group can assign 90% of his investment into stocks, investor of 50’s age
group must have not more than 40% allocated to equities. That’s why we need a
diversified portfolio.
Problems of Diversification
Investment in too many assets may lead to the
following problems:
1)
Purchase of bad stocks. While buying
stocks at random, sometimes, the investor may purchase certain stocks which
will not yield the expected return.
2)
Difficulty in obtaining information.
When there are too many securities in a portfolio, it becomes difficult for the
portfolio manager to obtain detailed information about their performance. In
the absence of information, he may not provide right advice as to what to buy
and what not to buy.
3)
Increased research cost. Before the
purchase of stocks, detailed analysis as to economic and technical performance
of individual stock has to be carried out. This requires collecting and
processing of information and storing the same. These procedures involve high
costs in terms of salaries to be paid to the analysts who are specialized
people in this field.
4)
Increased transaction cost. Some cost
has to be incurred whenever a stock is to be purchased. Purchasing stocks in
small quantities frequently involves higher transaction cost than the purchase
of large quantity in one go.
Or
(b) Define Markowitz
diversification theory. Explain the statistical method used by Markowitz to
reduce risk. 4+10=14
Ans:
MARKOWITZ MODEL: Dr. Harry M. Markowitz was the person who developed the first
modern portfolio analysis model. Markowitz used mathematical programming and
statistical analysis in order to arrange for the optimum allocation of assets
within portfolio. He infused a high degree of sophistication into portfolio
construction by developing a mean-variance model for the selection of
portfolio. Markowitz approach determines for the investors the efficient set of
portfolio through three importance variables - Return, standard deviation and
coefficient of correlation.
Markowitz model is called the “Full Covariance Model”. Through
this method the investor can find out the efficient set of portfolio by finding
out the tradeoff between risk and return, between the limits of zero and infinity.
Markowitz theory is based on several assumptions these are:
ASSUMPTIONS
OF MARKOWITZ’S MODEL
a)
The markets are efficient and absorb
all the information quickly and perfectly. So an investor can earn superior
returns either by technical analysis or fundamental analysis. All the investors
are in equal category in this regard.
b)
Investors are risk averse. Before
making any investments, all of them, have a common goal-avoidance of risk. But
practically this assumption does hold good. In a country like India, majority
of investors invests money on the basis of market news without doing any
technical and fundamental analysis.
c)
Investors are rational. They would
like to earn the maximum rate of return with a given level of income or money.
d)
Investors base their decisions solely
on expected return and variance (or standard deviation) of returns only.
e)
For a given risk level, investors
prefer high returns to lower returns. Similarly, for a given level of expected
return, they prefer less risk to more risk.
Standard Deviation and Beta of a Portfolio
Harry Markowitz developed Modern Portfolio Theory (MPT), which is
based on the concept of diversification to reduce investment risk. Modern
portfolio statistics attempt to show how an investment's volatility and return
measure against a given benchmark, such as BSE Index, NSE Index. Beta and
standard deviation are measures by which a portfolio or fund's level of risk is
calculated. Beta compares the volatility of an investment to a relevant
benchmark while standard deviation compares an investment's volatility to the
average return over a period of time. Standard deviation tells an investor a
more general story about the security's tendency to move up and down abruptly,
while beta tells the investor how much higher or lower a security will likely
trade in relation to an index.
Standard deviation: Standard deviation is a statistical
measurement that looks at historical volatility, indicating the tendency of the
returns to rise or fall considerably in a short period of time. A volatile
investment has a higher risk because its performance may change rapidly in
either direction at any moment. A higher standard deviation means an investment
is highly volatile, riskier and tends to yield higher returns. A lower standard
deviation means the investment is more consistent and moves less choppily. It
tends to yield more modest returns and presents a lower risk.
A volatile security or fund will have a high standard deviation
compared to that of a stable blue chip stock or a conservative fund investment
allocation. A large spread between deviations shows how much the return on the
security or fund differs from the expected "normal" returns. However,
the steady past performance of a fund does not guarantee a similar future
performance. Because unexpected market conditions can increase volatility, a
security that at one period had a standard deviation close or equal to zero may
perform otherwise during a different period.
Beta: Beta attempts to measure an investment's sensitivity to market
movements. A high beta means that an investment is highly volatile and that it
will likely outperform its benchmark in up markets, thus exceeding the
benchmark's return, and underperform it in down markets. A lower beta means an
investment is likely to underperform its benchmark in up markets, but is likely
to do better when the markets fall.
The first step in beta is measuring the volatility of a
benchmark's returns in excess of a risk-free asset's return, such as the
Treasury bill. The benchmark's beta is always 1.0. So a security with a beta of
0.83 is expected to gain 17 percent less, on average, than the benchmark in up
markets and expected to lose, on average, 17 percent less in down markets. By
contrast, a security with a beta of 1.13, is expected to gain, on average, 13
percent more than the benchmark in up markets, and lose, on average, 13 percent
more in down markets. However, beta does not calculate the odds of
macroeconomic changes nor does it take into consideration the herd-like
behavior of investors and its effect on the securities market.
5. (a) What are the basic
assumptions of Capital Asset Pricing Model? How would you evaluate a security
with the help of Capital Asset Pricing Model? 7+7=14
Ans: Assumptions of CAPM
The capital asset pricing model is based on certain explicit
assumptions regarding the behavior of investors. The assumptions are listed
below:
1.
Investor make their investment
decisions on the basis of risk-return assessments measured in terms of expected
returns and standard deviation of return.
2.
The purchase or sale of a security can
be undertaken in infinitely divisible unit.
3.
Purchase and sale by a single investor
cannot affect prices. This means that there is perfect competition where
investors in total determine prices by their action.
4.
There are no transaction costs. Given
the fact that transaction costs are small, they are probably of minor
importance in investment decision-making, and hence they are ignored.
5.
There are no personal income taxes.
Alternatively, the tax rate on dividend income and capital gains are the same,
thereby making the investor indifferent to the form in which the return on the
investment is received (dividends or capital gains).
6.
The investor can lend or borrow any
amount of fund desired at a rate of interest equal to the rate of risk less
securities.
7.
The investor can sell short any amount
of any shares.
8.
Investors share homogeneity of
expectations. This implies that investors have identical expectations with
regard to the decision period and decision inputs. Investors are presumed to
have identical expectations regarding expected returns, variance of expected
returns and covariance of all pairs of securities.
Evaluation of a Security
with the help of SAPM
The Capital Asset Pricing Model (CAPM) is a widely used method for evaluating the expected
Or
(b) What are the basic
assumptions behind the Arbitrage Pricing Theory (APT)? Distinguish between
Capital Asset Pricing Model and Arbitrage Pricing Theory. 7+7=14
Ans:
Basic assumptions of Arbitrage Pricing Theory
a)
It is based on the principle of
capital market efficiency and hence assumes all market participants trade with
the intention of profit maximisation.
b)
The Investors have homogenous
beliefs/expectations.
c)
Risk-return analysis is not the basis.
d)
It assumes no arbitrage exists and if
it occurs participants will engage to benefit out of it and bring back the
market to equilibrium levels.
e)
Capital markets are perfectly
competitive.
f)
The security returns are generated
according to a factor model. Several factors affect the return on a security.
g)
There are no transaction costs, no
taxes, short selling is possible and infinite number of securities is
available.
h)
The relationship between security
returns and factors is linear.
Difference between APT and CAPM
a)
APT computes the expected return on a
security based on the security’s sensitivity to movements in macroeconomic
factors. Whereas, CAPM is a tool used by
investors to determine the risk associated with a potential investment and also
gives an idea as to what can be the expected return on the investment.
b)
The APT can be set up to consider
several risk factors, such as the business cycle, interest rates, inflation
rates, and energy prices. The model distinguishes between systematic risk and
firm-specific risk and incorporates both types of risk into the model for each
given factor. Whereas CAPM considers
only systematic risk, reflecting a reality in which most investors have
diversified portfolios from which unsystematic risk has been essentially
eliminated.
c)
APT is based on factor model of return
and arbitrage Whereas CAPM is based on investors’ portfolio demand and
equilibrium.
d)
APT is a multifactor model whereas
CAPM is a single factor model.
e)
APT places emphasis on covariance
between asset returns and exogenous factors whereas CAPM places emphasis on
covariance between asset returns and endogenous factors.
f)
APT model works better in multi period
cases as against CAPM which is suitable for single period cases only.
6. (a) Define portfolio
performance evaluation. Discuss Jensen’s Differential Return Model in detail.
4+10=14
Ans: Portfolio performance evaluation can be
defined as a feedback and control mechanism which is used by the portfolio
managers and investment analysts to make the process of portfolio/investment
management more effective. Expert Portfolio managers have to show superior
performance over the market; for that they have to evaluate their performance
in comparison with other portfolio managers. Portfolio manager have an
objective to achieve an optimum risk return adjustment. Whether they are heading
towards this objective or not will be found out only if they evaluate their
portfolios periodically.
However,
in conducting such an evaluation, a means for determining the appropriate
standard or benchmark must be established. Two major factors which influence
the performance are the rate of return earned and the associated risk over the
relevant period. The return is defined to include changes in the value of the
fund over the performance period plus any income earned over that period. Risk
is the variability surrounding the return. The manager has to diversify
completely into different industries, assets and instruments so as to reduce
the unsystematic risk to the minimum for a given level of return. The
systematic or market related risk has to be managed by a proper selection of
beta for the securities.
Jensen Model
Jensen's model proposes another risk adjusted performance measure.
This measure was developed by Michael Jensen and is sometimes referred to as
the Differential Return Method. This measure involves evaluation of the returns
that the fund has generated vs. the returns actually expected out of the fund
given the level of its systematic risk. The surplus between the two returns is
called Alpha, which measures the performance of a fund compared with the actual
returns over the period. Required return of a fund at a given level of risk (b)
can be calculated as:
Rt – R = a + b (Rm – R)
Where, Rt = Portfolio Return
R = Risk less return
a = Intercept the graph that measures
the forecasting ability of the portfolio manager.
b = Beta coefficient, a measure of
systematic risk
Rm = Return of the market portfolio
Thus, Jensen’s equation involves two steps:
(i) First he calculates what the return of a given portfolio
should be on the basis of b, Rm and R.
(ii) He compares the actual realised return of the portfolio with
the calculated or predicted return. Greater the excess of realised return over
the calculated return, better is the performance of the portfolio.
Limitation of this model is that it considers only systematic risk
not the entire risk associated with the fund and an ordinary investor cannot
mitigate unsystematic risk, as his knowledge of market is primitive.
Graphic representation of Jensen’s model is a given in the
following figure:
The figure shows three lines showing negative, neutral and
positive values. The negative line shows that the management of the performed
portfolio is inferior. The positive line shows that superior quality of
management of funds. The neutral value shows that the performance of the fund
is similar to the performance of the market portfolio.
A comparison between the three models shows that the intercept of
the line is Sharpe and Treynor models is always at the origin, whereas Jensen’s
model it may be at the origin (a = 0), above the origin (a > 0) and even be
below the origin indicating a negative value (a < 0). The risk adjusted
measures have been criticized for using a market surrogate instead of the true
market portfolio. These measures have been unable to statistically distinguish
luck or change from skill except over very long period of time. Moreover, these
models rely heavily on the validity of CAPM. If in estimating the measures the
analyst assumes the wrong from of the CAPM in the market place, he will get
based measure of performance, usually in favour of low risk portfolios.
Or
(b) (1) Discuss the
components of performance as provided by E. Fama. 7
Ans: Components
of Performance: E. Fama has provided an analytical framework
to have a more detailed breakdown of the performance of the fund. This break
down is done in the following three ways:
1.
Stock
Selection: Overall performance of the fund can be
examined in terms of superior or inferior stock selection and the normal return
associated with a given level of risk. Thus, Total Excess Return = Selecting +
Risk.
To earn average returns, the fund managers
have to diversify. The market pays return only on the basis of systematic risk.
The level of diversification can be judged on the basis of the correlation
between the portfolio returns and the returns for a market portfolio. A
completely diversified portfolio is perfectly correlated with the market
portfolio, which is in turn completely diversified.
To earn the above average return, fund
managers will generally have to forsake some diversification that will have its
cost in terms of additional portfolio risk. Hence some additional return is
needed for this additional diversification risk. Capital Market Line (CML)
helps in determining the risk commensurate with the incurred risk.
2.
Market
Timing: If investors want to maximize their returns,
they must not only purchase the right security but must also know the right
time to purchase and sell. To generate superior performance better than the
market average, markets, have to be timed correctly. Market timing implies
assessing correctly the direction of the market, either bull or bear and
positioning the portfolio accordingly. When there is a forecast of declining
market, the managers should position the portfolio properly by increasing the
cash percentage of the portfolio or by decreasing the beta of the equity
portion of the portfolio. When the forecast is of rising market, the managers should
decrease the cash position or increase the beta of the equity portion of the
portfolio.
3.
Cash
Management Analysis: Cash management analysis was used by
Farrell to assess the degree to which variations in the cash percentage around
the long term average have benefited or detracted from fund performance. Two
indexes were constructed for each fund by Farrell:
Ø The
first index is based on the average cash to other asset allocation experienced
by the fund over the period of analysis.
Ø The
second index is based on a quarter to quarter changes experienced by the fund
over the period.
(2) X gives the following
information:
|
Portfolio |
RP |
Beta |
Rf |
|
A |
15 |
1.2 |
5% |
|
B |
12 |
0.8 |
5% |
|
C |
15 |
1.5 |
5% |
|
D |
12 |
1.0 |
5% |
Calculate the return on
portfolio A, B, C and D according to the Jensen’s Performance Index. 7
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