PORTFOLIO MANAGEMENT 6.

69
2.69

Risks Analysis of Investment in Distressed Securities : On the face, investment in distressed

securities appears to be a good proposition but following types of risks are needed to be analyzed.
(i) Liquidity Risk – These securities may be saleable in the market.
(ii) Event Risk – Any event that particularly effect the company not economy as a whole
(iii) Market Risk – This is another type of risk though it is not important.
(iv) Human Risk – The judge’s decision on the company in distress also play a big role.

TEST YOUR KNOWLEDGE

Theoretical Questions
1. Write short note on factors affecting decision of investment in fixed income securities.
2. Briefly explain the objectives of “Portfolio Management”.
3. Discuss the Capital Asset Pricing Model (CAPM) and its relevant assumptions.

Practical Questions
1. A stock costing ` 120 pays no dividends. The possible prices that the stock might sell for at
the end of the year with the respective probabilities are:
Price Probability
115 0.1

120 0.1
125 0.2
130 0.3

135 0.2
140 0.1
Required:

(i) Calculate the expected return.

(ii) Calculate the Standard deviation of returns.
2. Following information is available in respect of expected dividend, market price and market
condition after one year.

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Market condition Probability Market Price Dividend per share

` `
Good 0.25 115 9
Normal 0.50 107 5
Bad 0.25 97 3
The existing market price of equity share is ` 106 (F.V. ` 1), which is cum 10% bonus
debenture of ` 6 each, per share. M/s. X Finance Company Ltd. had offered the buy-back of
debentures at face value.
Find out the expected return and variability of returns of the equity shares if buyback offer is
accepted by the investor.
And also advise-Whether to accept buy-back offer?
3. Mr. A is interested to invest ` 1,00,000 in the securities market. He selected two securities B
and D for this purpose. The risk return profile of these securities are as follows :

Security Risk ( σ ) Expected Return (ER)

B 10% 12%
D 18% 20%
Co-efficient of correlation between B and D is 0.15.
You are required to calculate the portfolio return of the following portfolios of B and D to be
considered by A for his investment.
(i) 100 percent investment in B only;

(ii) 50 percent of the fund in B and the rest 50 percent in D;

(iii) 75 percent of the fund in B and the rest 25 percent in D; and
(iv) 100 percent investment in D only.

Also indicate that which portfolio is best for him from risk as well as return point of view?
4. Consider the following information on two stocks, A and B :

Year Return on A (%) Return on B (%)

2006 10 12
2007 16 18

You are required to determine:

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(i) The expected return on a portfolio containing A and B in the proportion of 40% and
60% respectively.

(ii) The Standard Deviation of return from each of the two stocks.
(iii) The covariance of returns from the two stocks.
(iv) Correlation coefficient between the returns of the two stocks.

(v) The risk of a portfolio containing A and B in the proportion of 40% and 60%.
5. Following is the data regarding six securities:

A B C D E F
Return (%) 8 8 12 4 9 8
Risk (Standard deviation) 4 5 12 4 5 6

(i) Assuming three will have to be selected, state which ones will be picked.
(ii) Assuming perfect correlation, show whether it is preferable to invest 75% in A and
25% in C or to invest 100% in E.
6. The historical rates of return of two securities over the past ten years are given. Calculate the
Covariance and the Correlation coefficient of the two securities:

Years: 1 2 3 4 5 6 7 8 9 10
Security 1: 12 8 7 14 16 15 18 20 16 22
(Return per cent)
Security 2: 20 22 24 18 15 20 24 25 22 20
(Return per cent)

7. An investor has decided to invest to invest ` 1,00,000 in the shares of two companies,
namely, ABC and XYZ. The projections of returns from the shares of the two companies along
with their probabilities are as follows:

Probability ABC(%) XYZ(%)

0.20 12 16
0.25 14 10
0.25 -7 28
0.30 28 -2

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You are required to

(i) Comment on return and risk of investment in individual shares.
(ii) Compare the risk and return of these two shares with a Portfolio of these shares in
equal proportions.
(iii) Find out the proportion of each of the above shares to formulate a minimum risk
portfolio.
8. The following information are available with respect of Krishna Ltd.
Year Krishna Ltd. Average Dividend Average Dividend Return on
share price per Share Market Index Yield Govt. bonds
` `
2012 245 20 2013 4% 7%
2013 253 22 2130 5% 6%
2014 310 25 2350 6% 6%
2015 330 30 2580 7% 6%
Compute Beta Value of the Krishna Ltd. at the end of 2015 and state your observation.
9. The distribution of return of security ‘F’ and the market portfolio ‘P’ is given below:

Probability Return %
F P
0.30 30 -10
0.40 20 20
0.30 0 30
You are required to calculate the expected return of security ‘F’ and the market portfolio ‘P’,
the covariance between the market portfolio and security and beta for the security.
10. Given below is information of market rates of Returns and Data from two Companies A and B:

Year 2007 Year 2008 Year 2009

Market (%) 12.0 11.0 9.0
Company A (%) 13.0 11.5 9.8
Company B (%) 11.0 10.5 9.5

You are required to determine the beta coefficients of the Shares of Company A and Company B.

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11. The returns on stock A and market portfolio for a period of 6 years are as follows:
Year Return on A (%) Return on market portfolio (%)
1 12 8
2 15 12
3 11 11
4 2 -4
5 10 9.5
6 -12 -2

You are required to determine:

(i) Characteristic line for stock A
(ii) The systematic and unsystematic risk of stock A.
12. The rates of return on the security of Company X and market portfolio for 10 periods
are given below:
Period Return of Security X (%) Return on Market Portfolio (%)
1 20 22
2 22 20
3 25 18
4 21 16
5 18 20
6 −5 8
7 17 −6
8 19 5
9 −7 6
10 20 11

(i) What is the beta of Security X?

(ii) What is the characteristic line for Security X?
13. Expected returns on two stocks for particular market returns are given in the following table:
Market Return Aggressive Defensive
7% 4% 9%
25% 40% 18%

You are required to calculate:

(a) The Betas of the two stocks.

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(b) Expected return of each stock, if the market return is equally likely to be 7% or 25%.
(c) The Security Market Line (SML), if the risk free rate is 7.5% and market return is
equally likely to be 7% or 25%.
(d) The Alphas of the two stocks.
14. A study by a Mutual fund has revealed the following data in respect of three securities:
Security σ (%) Correlation with Index, Pm
A 20 0.60
B 18 0.95
C 12 0.75

The standard deviation of market portfolio (BSE Sensex) is observed to be 15%.

(i) What is the sensitivity of returns of each stock with respect to the market?
(ii) What are the covariances among the various stocks?
(iii) What would be the risk of portfolio consisting of all the three stocks equally?
(iv) What is the beta of the portfolio consisting of equal investment in each stock?
(v) What is the total, systematic and unsystematic risk of the portfolio in (iv)?
15. Mr. X owns a portfolio with the following characteristics:
Security A Security B Risk Free security
Factor 1 sensitivity 0.80 1.50 0
Factor 2 sensitivity 0.60 1.20 0
Expected Return 15% 20% 10%

It is assumed that security returns are generated by a two factor model.

(i) If Mr. X has ` 1,00,000 to invest and sells short ` 50,000 of security B and purchases
` 1,50,000 of security A what is the sensitivity of Mr. X’s portfolio to the two factors?
(ii) If Mr. X borrows ` 1,00,000 at the risk free rate and invests the amount he borrows
along with the original amount of ` 1,00,000 in security A and B in the same proportion
as described in part (i), what is the sensitivity of the portfolio to the two factors?
(iii) What is the expected return premium of factor 2?
16. Mr. Tempest has the following portfolio of four shares:

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Name Beta Investment ` Lac.

Oxy Rin Ltd. 0.45 0.80
Boxed Ltd. 0.35 1.50
Square Ltd. 1.15 2.25
Ellipse Ltd. 1.85 4.50

The risk-free rate of return is 7% and the market rate of return is 14%.

Required.
(i) Determine the portfolio return. (ii) Calculate the portfolio Beta.
17. Mr. Abhishek is interested in investing ` 2,00,000 for which he is considering following three
alternatives:
(i) Invest ` 2,00,000 in Mutual Fund X (MFX)
(ii) Invest ` 2,00,000 in Mutual Fund Y (MFY)
(iii) Invest ` 1,20,000 in Mutual Fund X (MFX) and ` 80,000 in Mutual Fund Y (MFY)
Average annual return earned by MFX and MFY is 15% and 14% respectively. Risk free rate
of return is 10% and market rate of return is 12%.
Covariance of returns of MFX, MFY and market portfolio Mix are as follow:
MFX MFY Mix
MFX 4.800 4.300 3.370
MFY 4.300 4.250 2.800
Mix 3.370 2.800 3.100
You are required to calculate:
(i) variance of return from MFX, MFY and market return,
(ii) portfolio return, beta, portfolio variance and portfolio standard deviation,
(iii) expected return, systematic risk and unsystematic risk; and
(iv) Sharpe ratio, Treynor ratio and Alpha of MFX, MFY and Portfolio Mix.
18. Amal Ltd. has been maintaining a growth rate of 12% in dividends. The company has paid
dividend @ ` 3 per share. The rate of return on market portfolio is 15% and the risk-free rate
of return in the market has been observed as10%. The beta co-efficient of the company’s
share is 1.2.

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You are required to calculate the expected rate of return on the company’s shares as per
CAPM model and the equilibrium price per share by dividend growth model.
19. The following information is available in respect of Security X
Equilibrium Return 15%
Market Return 15%
7% Treasury Bond Trading at $140
Covariance of Market Return and Security Return 225%
Coefficient of Correlation 0.75

You are required to determine the Standard Deviation of Market Return and Security Return.
20. Assuming that shares of ABC Ltd. and XYZ Ltd. are correctly priced according to Capital
Asset Pricing Model. The expected return from and Beta of these shares are as follows:
Share Beta Expected return
ABC 1.2 19.8%
XYZ 0.9 17.1%

You are required to derive Security Market Line.

21. A Ltd. has an expected return of 22% and Standard deviation of 40%. B Ltd. has an expected
return of 24% and Standard deviation of 38%. A Ltd. has a beta of 0.86 and B Ltd. has a beta
of 1.24. The correlation coefficient between the return of A Ltd. and B Ltd. is 0.72. The
Standard deviation of the market return is 20%. Suggest:
(i) Is investing in B Ltd. better than investing in A Ltd.?
(ii) If you invest 30% in B Ltd. and 70% in A Ltd., what is your expected rate of return and
portfolio Standard deviation?
(iii) What is the market portfolios expected rate of return and how much is the risk-free
rate?
(iv) What is the beta of Portfolio if A Ltd.’s weight is 70% and B Ltd.’s weight is 30%?

22. XYZ Ltd. has substantial cash flow and until the surplus funds are utilised to meet the future
capital expenditure, likely to happen after several months, are invested in a portfolio of short-
term equity investments, details for which are given below:

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Investment No. of Beta Market price per share Expected

shares ` dividend yield
I 60,000 1.16 4.29 19.50%
II 80,000 2.28 2.92 24.00%
III 1,00,000 0.90 2.17 17.50%
IV 1,25,000 1.50 3.14 26.00%

The current market return is 19% and the risk free rate is 11%.
Required to:
(i) Calculate the risk of XYZ’s short-term investment portfolio relative to that of the market;
(ii) Whether XYZ should change the composition of its portfolio.
23. A company has a choice of investments between several different equity oriented mutual
funds. The company has an amount of `1 crore to invest. The details of the mutual funds are
as follows:
Mutual Fund Beta
A 1.6
B 1.0
C 0.9
D 2.0
E 0.6

Required:
(i) If the company invests 20% of its investment in each of the first two mutual funds and
an equal amount in the mutual funds C, D and E, what is the beta of the portfolio?
(ii) If the company invests 15% of its investment in C, 15% in A, 10% in E and the balance
in equal amount in the other two mutual funds, what is the beta of the portfolio?

(iii) If the expected return of market portfolio is 12% at a beta factor of 1.0, what will be
the portfolios expected return in both the situations given above?
24. Suppose that economy A is growing rapidly and you are managing a global equity fund and
so far you have invested only in developed-country stocks only. Now you have decided to
add stocks of economy A to your portfolio. The table below shows the expected rates of

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return, standard deviations, and correlation coefficients (all estimates are for aggregate stock
market of developed countries and stock market of Economy A).
Developed Stocks of Economy A
Country Stocks
Expected rate of return (annualized 10 15
percentage)
Risk [Annualized Standard Deviation (%)] 16 30
Correlation Coefficient (ρ) 0.30

Assuming the risk-free interest rate to be 3%, you are required to determine:
(a) What percentage of your portfolio should you allocate to stocks of Economy A if you
want to increase the expected rate of return on your portfolio by 0.5%?
(b) What will be the standard deviation of your portfolio assuming that stocks of Economy
A are included in the portfolio as calculated above?

(c) Also show how well the Fund will be compensated for the risk undertaken due to
inclusion of stocks of Economy A in the portfolio comparing with investment in
developed country’s stocks only.
25. Mr. FedUp wants to invest an amount of ` 520 lakhs and had approached his Portfolio
Manager. The Portfolio Manager had advised Mr. FedUp to invest in the following manner:
Security Moderate Better Good Very Good Best
Amount (in ` Lakhs) 60 80 100 120 160
Beta 0.5 1.00 0.80 1.20 1.50

You are required to advise Mr. FedUp in regard to the following, using Capital Asset Pricing
Methodology:

(i) Expected return on the portfolio, if the Government Securities are at 8% and the NIFTY
is yielding 10%.
(ii) Advisability of replacing Security 'Better' with NIFTY.

26. Your client is holding the following securities:

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Particulars of Securities Cost Dividends/Interest Market Beta

price
` ` `
Equity Shares:
Gold Ltd. 10,000 1,725 9,800 0.6
Silver Ltd. 15,000 1,000 16,200 0.8
Bronze Ltd. 14,000 700 20,000 0.6
GOI Bonds 36,000 3,600 34,500 0.01

Average return of the portfolio is 15.7%, calculate:

(i) Expected rate of return in each, using the Capital Asset Pricing Model (CAPM).

(ii) Risk free rate of return.

27. A holds the following portfolio:
Share/Bond Beta Initial Price Dividends Market Price at
end of year
` ` `
Epsilon Ltd. 0.8 25 2 50
Sigma Ltd. 0.7 35 2 60
Omega Ltd. 0.5 45 2 135
GOI Bonds 0.01 1,000 140 1,005

Calculate:
(i) The expected rate of return of each security using Capital Asset Pricing Method
(CAPM)
(ii) The average return of his portfolio.
Risk-free return is 14%.
28. Your client is holding the following securities:
Particulars of Cost Dividends Market Price BETA
Securities ` ` `
Equity Shares:
Co. X 8,000 800 8,200 0.8
Co. Y 10,000 800 10,500 0.7
Co. Z 16,000 800 22,000 0.5
PSU Bonds 34,000 3,400 32,300 0.2

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Assuming a Risk-free rate of 15%, calculate:

– Expected rate of return in each, using the Capital Asset Pricing Model (CAPM).
– Simple Average return of the portfolio.

29. An investor is holding 1,000 shares of Fatlass Company. Presently the rate of dividend being
paid by the company is ` 2 per share and the share is being sold at ` 25 per share in the
market. However, several factors are likely to be changed during the course of the year as
indicated below:
Existing Revised
Risk free rate 12% 10%
Market risk premium 6% 4%
Beta value 1.4 1.25
Expected growth rate 5% 9%

In view of the above factors whether the investor should buy, hold or sell the shares? And
why?
30. An investor is holding 5,000 shares of X Ltd. Current year dividend is ` 3 share. Market price
of the share is ` 40 each. The investor is concerned about several factors which are likely to
change during the next financial year as indicated below:
Current Year Next Year
Dividend paid /anticipated per share (`) 3 2.5
Risk free rate 12% 10%
Market Risk Premium 5% 4%
Beta Value 1.3 1.4
Expected growth 9% 7%

In view of the above, advise whether the investor should buy, hold or sell the shares.

31. An investor has two portfolios known to be on minimum variance set for a population of three
securities A, B and C having below mentioned weights:
WA WB WC
Portfolio X 0.30 0.40 0.30
Portfolio Y 0.20 0.50 0.30

It is supposed that there are no restrictions on short sales.

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(i) What would be the weight for each stock for a portfolio constructed by investing
` 5,000 in portfolio X and ` 3,000 in portfolio Y?.

(ii) Suppose the investor invests ` 4,000 out of ` 8,000 in security A. How he will allocate
the balance between security B and C to ensure that his portfolio is on minimum
variance set?

32. X Co., Ltd., invested on 1.4.2009 in certain equity shares as below:

Name of Co. No. of shares Cost (`)
M Ltd. 1,000 (` 100 each) 2,00,000
N Ltd. 500 (` 10 each) 1,50,000

In September, 2009, 10% dividend was paid out by M Ltd. and in October, 2009, 30% dividend
paid out by N Ltd. On 31.3.2010 market quotations showed a value of ` 220 and ` 290 per
share for M Ltd. and N Ltd. respectively.
On 1.4.2010, investment advisors indicate (a) that the dividends from M Ltd. and N Ltd. for
the year ending 31.3.2011 are likely to be 20% and 35%, respectively and (b) that the
probabilities of market quotations on 31.3.2011 are as below:
Probability factor Price/share of M Ltd. Price/share of N Ltd.
0.2 220 290
0.5 250 310
0.3 280 330
You are required to:
(i) Calculate the average return from the portfolio for the year ended 31.3.2010;
(ii) Calculate the expected average return from the portfolio for the year 2010-11; and
(iii) Advise X Co. Ltd., of the comparative risk in the two investments by calculating the
standard deviation in each case.
33. An investor holds two stocks A and B. An analyst prepared ex-ante probability distribution for
the possible economic scenarios and the conditional returns for two stocks and the market
index as shown below:
Economic scenario Probability Conditional Returns %
A B Market
Growth 0.40 25 20 18
Stagnation 0.30 10 15 13
Recession 0.30 -5 -8 -3

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The risk free rate during the next year is expected to be around 11%. Determine whether the
investor should liquidate his holdings in stocks A and B or on the contrary make fresh
investments in them. CAPM assumptions are holding true.
34. Following are the details of a portfolio consisting of three shares:

Share Portfolio weight Beta Expected return in % Total variance

A 0.20 0.40 14 0.015
B 0.50 0.50 15 0.025
C 0.30 1.10 21 0.100

Standard Deviation of Market Portfolio Returns = 10%

You are given the following additional data:
Covariance (A, B) = 0.030
Covariance (A, C) = 0.020
Covariance (B, C) = 0.040
Calculate the following:
(i) The Portfolio Beta
(ii) Residual variance of each of the three shares
(iii) Portfolio variance using Sharpe Index Model
(iv) Portfolio variance (on the basis of modern portfolio theory given by Markowitz)
35. Ramesh wants to invest in stock market. He has got the following information about individual
securities:
Security Expected Return Beta σ2 ci
A 15 1.5 40
B 12 2 20
C 10 2.5 30
D 09 1 10
E 08 1.2 20
F 14 1.5 30

Market index variance is 10 percent and the risk free rate of return is 7%. What should be the
optimum portfolio assuming no short sales?

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36. A Portfolio Manager (PM) has the following four stocks in his portfolio:
Security No. of Shares Market Price per share β
(`)
VSL 10,000 50 0.9
CSL 5,000 20 1.0
SML 8,000 25 1.5
APL 2,000 200 1.2

Compute the following:

(i) Portfolio beta.
(ii) If the PM seeks to reduce the beta to 0.8, how much risk free investment should he bring
in?
(iii) If the PM seeks to increase the beta to 1.2, how much risk free investment should he
bring in?
37. A has portfolio having following features:

Security β Random Error σei Weight

L 1.60 7 0.25
M 1.15 11 0.30
N 1.40 3 0.25
K 1.00 9 0.20

You are required to find out the risk of the portfolio if the standard deviation of the market
index (σm) is 18%.
38. Mr. Tamarind intends to invest in equity shares of a company the value of which
depends upon various parameters as mentioned below:
Factor Beta Expected value in % Actual value in %
GNP 1.20 7.70 7.70
Inflation 1.75 5.50 7.00
Interest rate 1.30 7.75 9.00
Stock market index 1.70 10.00 12.00
Industrial production 1.00 7.00 7.50

If the risk free rate of interest be 9.25%, how much is the return of the share under Arbitrage
Pricing Theory?

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39. The total market value of the equity share of O.R.E. Company is ` 60,00,000 and the total
value of the debt is ` 40,00,000. The treasurer estimate that the beta of the stock is currently
1.5 and that the expected risk premium on the market is 10 per cent. The treasury bill rate is
8 per cent.
Required:
(i) What is the beta of the Company’s existing portfolio of assets?

(ii) Estimate the Company’s Cost of capital and the discount rate for an expansion of the
company’s present business.
40. Mr. Nirmal Kumar has categorized all the available stock in the market into the following
types:
(i) Small cap growth stocks
(ii) Small cap value stocks
(iii) Large cap growth stocks
(iv) Large cap value stocks
Mr. Nirmal Kumar also estimated the weights of the above categories of stocks in the market
index. Further, the sensitivity of returns on these categories of stocks to the three important
factor are estimated to be:
Category of Weight in the Factor I Factor II Factor III
Stocks Market Index (Beta) (Book Price) (Inflation)
Small cap growth 25% 0.80 1.39 1.35
Small cap value 10% 0.90 0.75 1.25
Large cap growth 50% 1.165 2.75 8.65
Large cap value 15% 0.85 2.05 6.75
Risk Premium 6.85% -3.5% 0.65%

The rate of return on treasury bonds is 4.5%

Required:
(a) Using Arbitrage Pricing Theory, determine the expected return on the market index.
(b) Using Capital Asset Pricing Model (CAPM), determine the expected return on the
market index.

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(c) Mr. Nirmal Kumar wants to construct a portfolio constituting only the ‘small cap value’
and ‘large cap growth’ stocks. If the target beta for the desired portfolio is 1, determine
the composition of his portfolio.
41. The following are the data on five mutual funds:
Fund Return Standard Deviation Beta
A 15 7 1.25
B 18 10 0.75
C 14 5 1.40
D 12 6 0.98
E 16 9 1.50

You are required to compute Reward to Volatility Ratio and rank these portfolio using:
♦ Sharpe method and

♦ Treynor's method
assuming the risk free rate is 6%.
42. Five portfolios experienced the following results during a 7- year period:
Portfolio Average Standard Correlation with
Annual Return Deviation the market returns
(Rp) (%) (Sp) (r)
A 19.0 2.5 0.840
B 15.0 2.0 0.540
C 15.0 0.8 0.975
D 17.5 2.0 0.750
E 17.1 1.8 0.600
Market Risk (σm) 1.2
Market rate of Return (Rm) 14.0
Risk-free Rate (Rf) 9.0

Rank the portfolios using (a) Sharpe’s method, (b) Treynor’s method and (c) Jensen’s Alpha

ANSWERS/ SOLUTIONS
Answers to Theoretical Questions
1. Please refer paragraph 12.3.

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2. Please refer paragraph 1.2.

3. Please refer paragraph 8.

Answers to the Practical Questions

1. (i) Here, the probable returns have to be calculated using the formula
D P1 − P0
R
= +
P0 P0

Calculation of Probable Returns

Possible prices (P1) P1-P0 [(P1-P0)/ P0 ] x 100
` ` Return (per cent)
115 -5 -4.17
120 0 0.00
125 5 4.17
130 10 8.33
135 15 12.50
140 20 16.67

Alternatively, it can be calculated as follows:

Calculation of Expected Returns
Possible return Probability Product
Xi p(Xi) X1-p(Xi)
-4.17 0.1 -0.417
0.00 0.1 0.000
4.17 0.2 0.834
8.33 0.3 2.499
12.50 0.2 2.500
16.67 0.1 1.667
X = 7.083

Expected return X = 7.083 per

Alternatively, it can also be calculated as follows:
Expected Price = 115 x 0.1 + 120 x 0.1 + 125 x 0.2 + 130 x 0.3 + 135 x 0.2 + 140 x
0.1 = 128.50

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128.50 − 120
Return = × 100 = 7.0833%
120

(ii) Calculation of Standard Deviation of Returns

Probable Probability Deviation Deviation Product

squared
return Xi p(Xi) (Xi – X) (Xi – X)² (Xi – X)²p(Xi)
-4.17 0.1 -11.253 126.63 12.66
0.00 0.1 -7.083 50.17 5.017
4.17 0.2 -2.913 8.49 1.698
8.33 0.3 1.247 1.56 0.467
12.50 0.2 5.417 29.34 5.869
16.67 0.1 9.587 91.91 9.191
σ² = 34.902

Variance, σ² = 34.902 per cent

Standard deviation, σ= 34.902 = 5.908 per cent

2. The Expected Return of the equity share may be found as follows:

Market Condition Probability Total Return Cost (*) Net Return

Good 0.25 ` 124 ` 100 ` 24
Normal 0.50 ` 112 ` 100 ` 12
Bad 0.25 ` 100 ` 100 `0
 12 
Expected Return = (24 × 0.25) + (12 × 0.50) + (0 × 0.25) = 12=   × 100 =
12%
 100 

The variability of return can be calculated in terms of standard deviation.

V SD = 0.25 (24 – 12)2 + 0.50 (12 – 12)2 + 0.25 (0 – 12)2
= 0.25 (12)2 + 0.50 (0)2 + 0.25 (–12)2
= 36 + 0 + 36
SD = 72

SD = 8.485 or say 8.49

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 6.882.88 ADVANCED FINANCIAL MANAGEMENT

(*) The present market price of the share is ` 106 cum bonus 10% debenture of ` 6 each;
hence the net cost is ` 100.
M/s X Finance company has offered the buyback of debenture at face value. There is
reasonable 10% rate of interest compared to expected return 12% from the market.
Considering the dividend rate and market price the creditworthiness of the company seems
to be very good. The decision regarding buy-back should be taken considering the maturity
period and opportunity in the market. Normally, if the maturity period is low say up to 1 year
better to wait otherwise to opt buy back option.
3. We have Ep = W1E1 + W3E3 + ………… WnEn
n n
and for standard deviation σ2p = ∑∑ w i w jσ ij
i=1 j=1

n n
σ2p = ∑∑ w i w jρij σ i σ j
i=1 j=1

Two asset portfolio

σ2p = w21σ21 + w22σ22 + 2 w1w2σ1σ2ρ12
Substituting the respective values we get,
(i) All funds invested in B
Ep = 12%
σp = 10%
(ii) 50% of funds in each of B & D
Ep = 0.50X12%+0.50X20%=16%
σ2p = (0.50)2(10%)2 + (0.50)2(18%)2 +2(0.50)(0.50)(0.15)(10%)(18%)
σ2p = 25 + 81 + 13.5 = 119.50
σp = 10.93%

(iii) 75% in B and 25% in D

Ep = 0.75%X12%+0.25%X20=14%

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 PORTFOLIO MANAGEMENT 6.89
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σ2p = (0.75)2(10%)2 + (0.25)2(18%)2 +2(0.75)(0.25)(0.15)(10%)(18%)

σ2p = 56.25 + 20.25 + 10.125 = 86.625

σp = 9.31%
(iv) All funds in D
Ep = 20%

σp = 18.0%

Portfolio (i) (ii) (iii) (iv)

Return 12 16 14 20
σ 10 10.93 9.31 18

In the terms of return, we see that portfolio (iv) is the best portfolio. In terms of risk we
see that portfolio (iii) is the best portfolio.
4. (i) Expected return of the portfolio A and B
E (A) = (10 + 16) / 2 = 13%
E (B) = (12 + 18) / 2 = 15%
N
Rp = ∑ X iR i = 0.4(13) + 0.6(15) = 14.2%
i −l

(ii) Stock A:

Variance = 0.5 (10 – 13)² + 0.5 (16 – 13) ² = 9

Standard deviation = 9 = 3%
Stock B:

Variance = 0.5 (12 – 15) ² + 0.5 (18 – 15) ² = 9

Standard deviation = 3%
(iii) Covariance of stocks A and B
CovAB = 0.5 (10 – 13) (12 – 15) + 0.5 (16 – 13) (18 – 15) = 9
(iv) Correlation of coefficient

rAB = Cov AB = 9 = 1
σ A σB 3×3

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 6.902.90 ADVANCED FINANCIAL MANAGEMENT

(v) Portfolio Risk

σP = X 2 A σ2 A + X 2Bσ2B + 2X A X B (σ A σBσ AB )

= (0.4 )2 (3)2 + (0.6)2 (3)2 + 2(0.4 )(0.6)(3)(3)(1)

= 1.44 + 3.24 + 4.32 = 3%

5. (i) Security A has a return of 8% for a risk of 4, whereas B and F have a higher risk for
the same return. Hence, among them A dominates.
For the same degree of risk 4, security D has only a return of 4%. Hence, D is also
dominated by A.
Securities C and E remain in reckoning as they have a higher return though with higher
degree of risk.
Hence, the ones to be selected are A, C & E.
(ii) The average values for A and C for a proportion of 3 : 1 will be :
(3 × 4) + (1× 12)
Risk = = 6%
4
(3 × 8) + (1× 12)
Return = = 9%
4
Therefore: 75% A E
25% C _
Risk 6 5
Return 9% 9%
For the same 9% return the risk is lower in E. Hence, E will be preferable.
6. Calculation of Covariance
Ye R1 Deviatio Deviation R2 Deviation Deviation Product
ar n of
(R1 - R1) 2 (R 2 - R 2 ) (R 2 - R 2 ) 2
(R 1 - R1 ) deviation
s
1 12 -2.8 7.84 20 -1 1 2.8
2 8 -6.8 46.24 22 1 1 -6.8
3 7 -7.8 60.84 24 3 9 -23.4
4 14 -0.8 0.64 18 -3 9 2.4
5 16 1.2 1.44 15 -6 36 -7.2

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6 15 0.2 0.04 20 -1 1 -0.2

7 18 3.2 10.24 24 3 9 9.6
8 20 5.2 27.04 25 4 16 20.8
9 16 1.2 1.44 22 1 1 1.2
10 22 7.2 51.84 20 -1 1 -7.2
148 Σ=207.60 210 Σ=84.00
R1
= = 14.8 R2
= = 21
10 10
N

∑ [R 1 − R 1 ] [R 2 − R 2 ]
Covariance = i =1
= -8/10 = -0.8
N

Standard Deviation of Security 1

(R1 - R1) 2
σ1 =
N
207.60
σ1 = = 20.76
10

σ1 = 4.56

Standard Deviation of Security 2

(R 2 - R 2 ) 2
σ2 =
N
84
σ2 = = 8.40
10

σ 2 = 2.90

Alternatively, Standard Deviation of securities can also be calculated as follows:

Calculation of Standard Deviation
Year R1 R 12 R2 R 22
1 12 144 20 400
2 8 64 22 484
3 7 49 24 576
4 14 196 18 324
5 16 256 15 225
6 15 225 20 400

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 6.922.92 ADVANCED FINANCIAL MANAGEMENT

7 18 324 24 576
8 20 400 25 625
9 16 256 22 484
10 22 484 20 400
148 2398 210 4494

Standard deviation of security 1:

σ1 =
N ∑R12 - (∑R1)2
N2

(10 × 2398) - (148) 2 23980 - 21904

=
10 ×10 100
=
20.76
= = 4.56
Standard deviation of security 2:

σ2 =
N ∑ R − (∑ R
2
2 2)
2

N2

(10 × 4494) − (210) 2

=
10 × 10 44940− 44100
=
100

840
= = 8.4 = 2.90
100

Correlation Coefficient
Cov − 0.8 − 0.8
r12 = =
σ1 σ 2 = 4.56 × 2.90 13.22 = -0.0605

7. (i)

Probability ABC (%) XYZ (%) 1X2 (%) 1X3 (%)

(1) (2) (3) (4) (5)
0.20 12 16 2.40 3.2
0.25 14 10 3.50 2.5
0.25 -7 28 -1.75 7.0

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 PORTFOLIO MANAGEMENT 6.93
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0.30 28 -2 8.40 -0.6

Average return 12.55 12.1

Hence the expected return from ABC = 12.55% and XYZ is 12.1%

Probability (ABC- ABC ) (ABC-ABC)2 1X3 (XYZ-XYZ) (XYZ-XYZ)2 (1)X(6)

(1) (2) (3) (4) (5) (6)
0.20 -0.55 0.3025 0.06 3.9 15.21 3.04
0.25 1.45 2.1025 0.53 -2.1 4.41 1.10
0.25 -19.55 382.2025 95.55 15.9 252.81 63.20
0.30 15.45 238.7025 71.61 -14.1 198.81 59.64
167.75 126.98

σ 2 ABC = 167.75(%)2 ; σ ABC = 12.95%

σ 2 XYZ = 126.98(%)2 ; σ XYZ = 11.27%

(ii) In order to find risk of portfolio of two shares, the covariance between the two is
necessary here.
Probability (ABC-ABC) (XYZ-XYZ) 2X3 1X4
(1) (2) (3) (4) (5)
0.20 -0.55 3.9 -2.145 -0.429
0.25 1.45 -2.1 -3.045 -0.761
0.25 -19.55 15.9 -310.845 -77.71
0.30 15.45 -14.1 -217.845 -65.35
-144.25

σ 2P = (0.52 x 167.75) + (0.52 x 126.98) + 2 x (-144.25) x 0.5 x 0.5

σ 2P = 41.9375 + 31.745 – 72.125
σ 2P = 1.5575 or 1.56(%)
σ P = 1.56 = 1.25%
E (Rp) = (0.5 x 12.55) + (0.5 x 12.1) = 12.325%
Hence, the return is 12.325% with the risk of 1.25% for the portfolio. Thus, the portfolio
results in the reduction of risk by the combination of two shares.

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 6.942.94 ADVANCED FINANCIAL MANAGEMENT

(iii) For constructing the minimum risk portfolio the condition to be satisfied is

σ X2 - rAX σ A σ X σ 2X - Cov.AX
XABC = or =
σ 2A + σ X2 - 2rAX σ A σ X σ 2A + σ 2X - 2 Cov.AX

σX = Std. Deviation of XYZ

σA = Std. Deviation of ABC
rAX= Coefficient of Correlation between XYZ and ABC
Cov.AX = Covariance between XYZ and ABC.
Therefore,
126.98 - (-144.25) 271.23
% ABC = = = 0.46 or 46%
126.98 + 167.75 - [2 × (-144.25) ] 583.23

% ABC = 46%, XYZ = 54%

(1 – 0.46) =0.54
8. (i) Computation of Beta Value
Calculation of Returns
D1 + (P1 − P0 )
Returns = × 100
P0

Year Returns
22 + (253 − 245)
2012 – 13 × 100 = 12.24%
245
25 + (310 − 253)
2013 – 14 × 100 = 32.41%
253
30 + (330 − 310)
2014 – 15 × 100 = 16.13%
310

Calculation of Returns from market Index

Year % of Index Appreciation Dividend Yield Total Return
% %
2012–13 (2130 − 2013) 5% 10.81%
× 100 = 5.81%
2013

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 PORTFOLIO MANAGEMENT 6.95
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2013–14 (2350 − 2130) 6% 16.33%

× 100 = 10.33%
2130
2014–15 (2580 − 2350) 7% 16.79%
× 100 = 9.79%
2350
Computation of Beta
Year Krishna Ltd. (X) Market Index (Y) XY Y2
2012–13 12.24% 10.81% 132.31 116.86
2013–14 32.41% 16.33% 529.25 266.67
2014–15 16.13% 16.79% 270.82 281.90
Total 60.78% 43.93% 932.38 665.43

60.78
Average Return of Krishna Ltd. = = 20.26%
3
43.93
Average Market Return = = 14.64%
3

Beta (β) =
∑ XY - nX Y = 932.38 - 3 × 20.26 × 14.64
= 1.897
∑ Y − n(Y ) 665.43 - 3(14.64)2
2 2

(ii) Observation
Expected Return (%) Actual Action
Return (%)
2012 – 13 6%+ 1.897(10.81% - 6%) = 15.12% 12.24% Sell
2013 – 14 6%+ 1.897(16.33% - 6%) = 25.60% 32.41% Buy
2014 – 15 6%+ 1.897(16.79% - 6%) = 26.47% 16.13% Sell

9. Security F
Prob(P) Rf PxRf Deviations of F (Deviation) 2 (Deviations) 2 PX
(Rf – ERf) of F
0.3 30 9 13 169 50.7
0.4 20 8 3 9 3.6
0.3 0 0 -17 289 86.7
ER f =17 Var f =141

STDEV σ f = 141 = 11.87

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 6.962.96 ADVANCED FINANCIAL MANAGEMENT

Market Portfolio, P
RM PM Exp. Dev. of P (Dev. of (DeV.) 2 (Deviation of F) Dev. of F x
% Return (RM -ERM ) P) 2 PM x (Deviation of Dev. of P) x P
RM x PM P)
-10 0.3 -3 -24 576 172.8 -312 -93.6
20 0.4 8 6 36 14.4 18 7.2
30 0.3 9 16 256 76.8 -272 -81.6
ERM =14 Var M =264 =Co Var PM
σ M =16.25 =- 168

Co Var PM − 168
Beta= = = − .636
σ M2 264

10. Company A:

Year Return % Market return Deviation Deviation D Ra × Rm 2

(Ra) % (Rm) R(a) Rm DRm
1 13.0 12.0 1.57 1.33 2.09 1.77
2 11.5 11.0 0.07 0.33 0.02 0.11
3 9.8 9.0 −1.63 −1.67 2.72 2.79
34.3 32.0 4.83 4.67

Average Ra = 11.43
Average Rm = 10.67

Covariance =
∑ (Rm - Rm )(Ra - R a )
N
4.83
Covariance = = 1.61
3

Variance (σm 2) =
∑ (R m - R m ) 2
N
4.67
= = 1.557
3
1.61
β= = 1.03
1.557

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Company B:

Year Return % Market return Deviation Deviation D Rb × D Rm2

(Rb) % (Rm) R(b) Rm Rm
1 11.0 12.0 0.67 1.33 0.89 1.77
2 10.5 11.0 0.17 0.33 0.06 0.11
3 9.5 9.0 −0.83 −1.67 1.39 2.79
31.0 32.0 2.34 4.67

Average Rb = 10.33
Average Rm = 10.67

Covariance =
∑ (Rm - Rm )(Rb - Rb )
N
2.34
Covariance = = 0.78
3

Variance (σ m 2 ) =
∑ (Rm - Rm )2
N
4.67
= = 1.557
3
0.78
β= = 0.50
1.557
11. Characteristic line is given by
αi+ βiRm

βi = Σxy − n x y
Σx 2 − n(x) 2

αi = y − β x
Return Return on xy x2 (x- x) (x- x) 2 (y- y ) (y- y ) 2
on A market
(Y) (X)
12 8 96 64 2.25 5.06 5.67 32.15
15 12 180 144 6.25 39.06 8.67 75.17

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 6.982.98 ADVANCED FINANCIAL MANAGEMENT

11 11 121 121 5.25 27.56 4.67 21.81

2 -4 -8 16 -9.75 95.06 -4.33 18.75
10 9.5 95 90.25 3.75 14.06 3.67 13.47
-12 -2 24 4 -7.75 60.06 -18.33 335.99
38 34.5 508 439.25 240.86 497.34

y = 38 = 6.33
6

x = 34.5 = 5.75
6
Σxy − n x y 508 − 6 (5.75) (6.33) 508 − 218.385
βi = 2 2
= 2
=
Σx − n( x) 439.25 − 6(5.75) 439.25 −198.375

289.615
= = 1.202
240.875

α = y - β x = 6.33 – 1.202 (5.75) = - 0.58

Hence the characteristic line is -0.58 + 1.202 (Rm)

240.86
Total Risk of Market = σ m 2 = Σ( x - x ) 2 = = 40.14(%)
n 6
497.34
Total Risk of Stock = = 82.89 (%)
6
Systematic Risk = βi 2 σ m2 = (1.202)2 x 40.14 = 57.99(%)

Unsystematic Risk is = Total Risk – Systematic Risk

= 82.89 - 57.99 = 24.90(%)

12. (i)
Period R X RM R − R X R − RM
X M (R X )(
− R X RM − RM ) (R M − RM )
2

1 20 22 5 10 50 100
2 22 20 7 8 56 64
3 25 18 10 6 60 36
4 21 16 6 4 24 16
5 18 20 3 8 24 64
6 -5 8 -20 -4 80 16
7 17 -6 2 -18 -36 324

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8 19 5 4 -7 -28 49
9 -7 6 -22 -6 132 36
10 20 11 5 -1 -5 1
150 120 357 706
ΣRX ΣRM ∑ (R X − R X )(R M − R M ) ∑ (R M − R M )
2

R X = 15 R M = 12
2
 −

∑ RM − RM 
  706
σ2 M = n = 10 = 70.60
 −
 −

∑  R X − R X  R M − R M 
  357
CovX M= n = 10 = 35.70
Cov X M m 35.70
Betax = = = 0.505
σ 2M 70.60

Alternative Solution

Period X Y Y2 XY
1 20 22 484 440
2 22 20 400 440
3 25 18 324 450
4 21 16 256 336
5 18 20 400 360
6 -5 8 64 -40
7 17 -6 36 -102
8 19 5 25 95
9 -7 6 36 -42
10 20 11 121 220
150 120 2146 2157

X = 15 Y = 12

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 2.
6.100 ADVANCED FINANCIAL MANAGEMENT
100

ΣXY - n X Y
=
ΣX 2 - n(X)2
2157 - 10 × 15 × 12 357
= = = 0.506
2146 - 10 × 12 × 12 706

(ii) R X = 15 R M = 12
y = α + βx
15 = α + 0.505 × 12
Alpha (α) = 15 – (0.505 × 12) = 8.94%
Characteristic line for security X = α + β × RM

Where, RM = Expected return on Market Index

∴Characteristic line for security X = 8.94 + 0.505 RM

13. (a) The Betas of two stocks:

Aggressive stock - (40% - 4%)/(25% - 7%) = 2
Defensive stock - (18% - 9%)/(25% - 7%) = 0.50
Alternatively, it can also be solved by using the Characteristic Line Relationship as
follows:
Rs = α + βRm
Where
α = Alpha
β = Beta
Rm= Market Return
For Aggressive Stock
4% = α + β(7%)
40% = α + β(25%)
36% = β(18%)
β=2
For Defensive Stock

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 PORTFOLIO MANAGEMENT 6.101
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9% = α + β(7%)
18% = α + β(25%)
9% = β(18%)
β =0.50
(b) Expected returns of the two stocks:-
Aggressive stock - 0.5 x 4% + 0.5 x 40% = 22%
Defensive stock - 0.5 x 9% + 0.5 x 18% = 13.5%
(c) Expected return of market portfolio = 0.5 x 7% + 0.5% x 25% = 16%
∴ Market risk prem. = 16% - 7.5% = 8.5%
∴ SML is, required return = 7.5% + βi 8.5%
(d) Rs = α + βRm

For Aggressive Stock

22% = αA + 2(16%)
αA = -10%

For Defensive Stock

13.5% = αD + 0.50(16%)
αD = 5.5%

14. (i) Sensitivity of each stock with market is given by its beta.
Standard deviation of market Index = 15%
Variance of market Index = 0.0225
Beta of stocks = σi r/ σ m

A = 20 × 0.60/15 = 0.80
B = 18 × 0.95/15 = 1.14

C = 12 × 0.75/15 = 0.60
(ii) Covariance between any 2 stocks = β1β 2 σ 2m

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Covariance matrix

Stock/Beta 0.80 1.14 0.60

A 400.000 205.200 108.000

B 205.200 324.000 153.900
C 108.000 153.900 144.000

(iii) Total risk of the equally weighted portfolio (Variance) = 400(1/3)2 + 324(1/3)2 +
144(1/3)2 + 2 (205.20)(1/3)2 + 2(108.0)(1/3)2 + 2(153.900) (1/3)2 = 200.244
0.80 + 1.14 + 0.60
(iv) β of equally weighted portfolio = β p = ∑ β i/N =
3
= 0.8467
(v) Systematic Risk β P2 σ m2 = (0.8467)2 (15)2 =161.302

Unsystematic Risk = Total Risk – Systematic Risk

= 200.244 – 161.302 = 38.942
15. (i) Mr. X’s position in the two securities are +1.50 in security A and -0.5 in security B.
Hence the portfolio sensitivities to the two factors:-
b prop. 1 =1.50 x 0.80 + (-0.50 x 1.50) = 0.45
b prop. 2 = 1.50 x 0.60 + (-0.50 x 1.20) = 0.30
(ii) Mr. X’s revised position:-
Security A ` 3,00,000 / ` 1,00,000 = 3

Security B -` 1,00,000 / ` 1,00,000 = -1

Risk free asset -` 100000 / ` 100000 = -1
b prop. 1 = 3.0 x 0.80 + (-1 x 1.50) + (- 1 x 0) = 0.90

b prop. 2 = 3.0 x 0.60 + (-1 x 1.20) + (-1 x 0) = 0.60

(iii) Expected Return = Risk Free Rate of Return + Risk Premium
Let λ1 and λ2 are the Value Factor 1 and Factor 2 respectively.

Accordingly

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 PORTFOLIO MANAGEMENT 6.103
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15 = 10 + 0.80 λ1 + 0.60 λ2
20 = 10 + 1.50 λ1 + 1.20 λ2
On solving equation, the value of λ1 = 0, and risk premium of factor 2 for Securities A
& B shall be as follows:
Using Security A’s Return
Total Return = 15% = 10% + 0.60 λ2
Risk Premium (λ2) = 5%/ 0.60 = 8.33%
Alternatively using Security B’s Return

Total Return = 20% = 10 + 1.20 λ2

Risk Premium = 10%/ 1.20 = 8.33%
16. Market Risk Premium (A) = 14% – 7% = 7%
Share Beta Risk Premium Risk Free Return Return
(Beta x A) % Return % % `
Oxy Rin Ltd. 0.45 3.15 7 10.15 8,120
Boxed Ltd. 0.35 2.45 7 9.45 14,175
Square Ltd. 1.15 8.05 7 15.05 33,863
Ellipse Ltd. 1.85 12.95 7 19.95 89,775
Total Return 1,45,933

Total Investment ` 9,05,000

` 1,45,933
(i) Portfolio Return = × 100 = 16.13%
` 9,05,000

(ii) Portfolio Beta

Portfolio Return = Risk Free Rate + Risk Premium х β = 16.13%
7% + 7β = 16.13%

β = 1.30
Alternative Approach

First we shall compute Portfolio Beta using the weighted average method as follows:

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 2.
6.104 ADVANCED FINANCIAL MANAGEMENT
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0.80 1.50 2.25 4.50

BetaP = 0.45 x + 0.35 x + 1.15 x + 1.85 x
9.05 9.05 9.05 9.05
= 0.45 x 0.0884 + 0.35 x 0.1657 + 1.15 x 0.2486 + 1.85 x 0.4972
= 0.0398 + 0.058 + 0.2859 + 0.9198 = 1.3035

Accordingly,
(i) Portfolio Return using CAPM formula will be as follows:
RP= RF + βP(RM – RF)

= 7% + 1.3035(14% - 7%) = 7% + 1.3035(7%)

= 7% + 9.1245% = 16.1245%
(ii) Portfolio Beta
As calculated above 1.3035
17. (i) Variance of Returns
Cov (i, j)
Cor i,j =
σ iσ j

Accordingly, for MFX

Cov (X,X)
1=
σ σ
X X

σ 2X = 4.800

Accordingly, for MFY

Cov (Y,Y)
1=
σ σ
Y Y

σ 2Y = 4.250

Accordingly, for Market Return

Cov (M,M)
1=
σ σ
M M

σ M2 = 3.100

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 PORTFOLIO MANAGEMENT 6.105
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Alternatively, by referring diagonally the given Table these values can identified as
follows:

VarianceX = 4.800
VarianceY = 4.250
VarianceM = 3.100

(ii) Portfolio return, beta, variance and standard deviation

1,20,000
Weight of MFX in portfolio = =0.60
2,00,000
80,000
Weight of MFY in portfolio = =0.40
2,00,000

Accordingly Portfolio Return

0.60 × 15% + 0.40 × 14% = 14.60%
Beta of each Fund
Cov (Fund,Market )
β=
Variance of Market
3.370
β = = 1.087
X 3.100
2.800
β = = 0.903
Y 3.100

Portfolio Beta
0.60 x 1.087 + 0.40 x 0.903 = 1.013
Portfolio Variance
σ 2XY = w 2X σ 2X + w 2Y σ 2Y + 2 w X w Y Cov X,Y
= (0.60)2 (4.800) + (0.40)2 (4.250) + 2(0.60) (0.40) (4.300)
= 4.472
Or Portfolio Standard Deviation

σ XY = 4.472 = 2.115
(iii) Expected Return, Systematic and Unsystematic Risk of Portfolio
Portfolio Return = 10% + 1.0134(12% - 10%) = 12.03%

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MF X Return = 10% + 1.087(12% - 10%) = 12.17%

MF Y Return = 10% + 0.903(12% - 10%) = 11.81%
Systematic Risk = β 2 σ 2

Accordingly,
Systematic Risk of MFX = (1.087)2 x 3.10 = 3.663
Systematic Risk of MFY = (0.903)2 x 3.10 = 2.528

Systematic Risk of Portfolio = (1.013)2 x 3.10 = 3.181

Unsystematic Risk = Total Risk – Systematic Risk
Accordingly,
Unsystematic Risk of MFX = 4.80 – 3.663 = 1.137
Unsystematic Risk of MFY = 4.250 – 2.528 = 1.722
Unsystematic Risk of Portfolio = 4.472 – 3.181 = 1.291
(iv) Sharpe and Treynor Ratios and Alpha
Sharpe Ratio
15% - 10%
MFX = = 2.282
4.800
14% - 10%
MFY = = 1.94
4.250
14.6% - 10%
Portfolio = = 2.175
2.115
Treynor Ratio
15% - 10%
MFX = = 4.60
1.087
14% - 10%
MFY = = 4.43
0.903
14.6% - 10%
Portfolio = = 4.54
1.0134
Alpha

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MFX = 15% - 12.17% = 2.83%

MFY = 14% - 11.81% = 2.19%
Portfolio = 14.6% - 12.03% = 2.57%
18. Capital Asset Pricing Model (CAPM) formula for calculation of expected rate of return is
ER = Rf + β (Rm – Rf)

ER = Expected Return
β = Beta of Security
Rm = Market Return

Rf = Risk free Rate

= 10 + [1.2 (15 – 10)]
= 10 + 1.2 (5)
= 10 + 6 = 16% or 0.16
Applying dividend growth mode for the calculation of per share equilibrium price:-
D1
ER = +g
P0

or 0.16 = 3(1.12) + 0.12 or 0.16 – 0.12 = 3.36

P0 P0

3.36
or 0.04 P0 = 3.36 or P0 = = ` 84
0.04
Therefore, equilibrium price per share will be ` 84.
19. First we shall compute the β of Security X.
7
Risk Free Rate = Coupon Payment = = 5%
Current Market Price 140

Assuming equilibrium return to be equal to CAPM return then:

15% = Rf + βX(Rm- Rf)
15%= 5% + βX(15%- 5%)
βX = 1
or it can also be computed as follows:

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R m 15%
= =1
R s 15%

(i) Standard Deviation of Market Return

Cov X,m 225%
βm = = =1
σm2 σm2

σ2m = 225
σm = 225 = 15%

(ii) Standard Deviation of Security Return

σX
βX = × ρXm = σX × 0.75 =1
σm 15

15
σX = = 20%
0.75
20. CAPM = Rf+ β (Rm –Rf)
Accordingly
RABC = Rf+1.2 (Rm – Rf) = 19.8
RXYZ = Rf+ 0.9 (Rm – Rf) = 17.1
19.8 = Rf+1.2 (Rm – Rf) ------(1)
17.1 = Rf+0.9 (Rm – Rf) ------(2)
Deduct (2) from (1)
2.7 = 0.3 (Rm – R f)
Rm – Rf = 9
R f = Rm – 9
Substituting in equation (1)
19.8 = (Rm – 9) + 1.2 (Rm – Rm+ 9)
19.8 = Rm - 9 + 10.8
19.8 = Rm+1.8
Then Rm=18% and Rf= 9%
Security Market Line
= Rf + β (Market Risk Premium)
= 9% + β × 9%

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21. (i) A Ltd. has lower return and higher risk than B Ltd. Hence, investing in B Ltd. is better
than in A Ltd. because the return is higher and the risk is lower. However, investing in
both will yield diversification advantage.
(ii) rAB = 0.22 × 0.7 + 0.24 × 0.3 = 0.226 i.e. 22.6%

σ 2AB = 0.402 X 0.72 + 0.382 X 0.32 + 2X 0.7 X 0.3 X 0.72 X 0.40 X 0.38 = 0.1374

σ AB = σ 2AB = 0.1374 = 0.37 = 37%

* Answer = 37.06% is also correct and variation may occur due to approximation.
(iii) This risk-free rate will be the same for A and B Ltd. Their rates of return are given as
follows:
rA = 22 = rf + (rm – rf) 0.86
rB = 24 = rf + (rm – rf) 1.24
rA – rB = –2 = (rm – rf) (–0.38)
rm – rf = –2/–0.38 = 5.26%
rA = 22 = rf + (5.26) 0.86
rf = 17.48%
Or
rB = 24 = rf + (5.26) 1.24
rf = 17.48%
rm – 17.48 = 5.26
rm = 22.74%
(iv) βAB = βA × WA + βB × WB
= 0.86 × 0.7 + 1.24 × 0.3 = 0.974
22. (i) Computation of Beta of Portfolio
Investment No. of Market Market Dividend Dividend Composition β Weighted
shares Price Value Yield β
I 60,000 4.29 2,57,400 19.50% 50,193 0.2339 1.16 0.27
II 80,000 2.92 2,33,600 24.00% 56,064 0.2123 2.28 0.48
III 1,00,000 2.17 2,17,000 17.50% 37,975 0.1972 0.90 0.18
IV 1,25,000 3.14 3,92,500 26.00% 1,02,050 0.3566 1.50 0.53
11,00,500 2,46,282 1.0000 1.46

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2,46,282
Return of the Portfolio = 0.2238
11,00,500

Beta of Port Folio 1.46

Market Risk implicit

0.2238 = 0.11 + β× (0.19 – 0.11)

Or, 0.08 β + 0.11 = 0.2238
0.2238 − 0.11
β= = 1.42
0.08
Market β implicit is 1.42 while the port folio β is 1.46. Thus the portfolio is marginally
risky compared to the market.
(ii) The decision regarding change of composition may be taken by comparing the
dividend yield (given) and the expected return as per CAPM as follows:
Expected return Rs as per CAPM is:
Rs = IRF + (RM – I RF)β
For investment I Rs = IRF + (RM – IRF)β
= .11 + (.19 - .11) 1.16
= 20.28%
For investment II, Rs = .11 + (.19 - .11) 2.28 = 29.24%
For investment III, Rs = .11 + (.19 - .11) .90
= 18.20%
For investment IV, Rs = .11 + (.19 - .11) 1.50
= 23%
Comparison of dividend yield with the expected return Rs shows that the dividend
yields of investment I, II and III are less than the corresponding Rs,. So, these
investments are over-priced and should be sold by the investor. However, in case of
investment IV, the dividend yield is more than the corresponding Rs, so, XYZ Ltd.
should increase its proportion.

23. With 20% investment in each MF Portfolio Beta is the weighted average of the Betas of
various securities calculated as below:

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(i)
Investment Beta (β) Investment Weighted
(` Lacs) Investment
A 1.6 20 32
B 1.0 20 20
C 0.9 20 18
D 2.0 20 40
E 0.6 20 12
100 122
Weighted Beta (β) = 1.22

(ii) With varied percentages of investments portfolio beta is calculated as follows:

Investment Beta (β) Investment Weighted
(` Lacs) Investment
A 1.6 15 24
B 1.0 30 30
C 0.9 15 13.5
D 2.0 30 60
E 0.6 10 6
100 133.5
Weighted Beta (β) = 1.335

(iii) Expected return of the portfolio with pattern of investment as in case (i)
= 12% × 1.22 i.e. 14.64%
Expected Return with pattern of investment as in case (ii) = 12% × 1.335 i.e., 16.02%.
24. (a) Let the weight of stocks of Economy A be expressed as w, then
(1- w)×10.0 + w ×15.0 = 10.5
i.e. w = 0.1 or 10%.
(b) Variance of portfolio shall be:
(0.9)2 (0.16) 2 + (0.1)2 (0.30) 2+ 2(0.9) (0.1) (0.16) (0.30) (0.30) = 0.02423

Standard deviation is (0.02423)½= 0.15565 or 15.6%.

(c) The Sharpe ratio will improve by approximately 0.04, as shown below:

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Expected Return - RiskFree Rate of Return

Sharpe Ratio =
Standard Deviation
10 - 3
Investment only in developed countries: = 0.437
16
10.5 - 3
With inclusion of stocks of Economy A: = 0.481
15.6
25. (i) Computation of Expected Return from Portfolio

Security Beta Expected Return (r) Amount Weights wr

(β) as per CAPM (` Lakhs) (w)
Moderate 0.50 8%+0.50(10% - 8%) = 9% 60 0.115 1.035
Better 1.00 8%+1.00(10% - 8%) = 10% 80 0.154 1.540
Good 0.80 8%+0.80 (10% - 8%) = 9.60% 100 0.192 1.843
Very Good 1.20 8%+1.20(10% - 8%) = 10.40% 120 0.231 2.402
Best 1.50 8%+1.50(10% - 8%) = 11% 160 0.308 3.388
Total 520 1 10.208

Thus Expected Return from Portfolio 10.208% say 10.21%.

Alternatively, it can be computed as follows:
60 80 100 120 160
Average β = 0.50 x + 1.00 x + 0.80 x + 1.20 x + 1.50 x = 1.104
520 520 520 520 520
As per CAPM
= 0.08 + 1.104(0.10 – 0.08) = 0.10208 i.e. 10.208%
(ii) As computed above the expected return from Better is 10% same as return from Nifty,
hence there will be no difference even if the replacement of security is made. The main
logic behind this neutrality is that the beta of security ‘Better’ is 1 which clearly
indicates that this security shall yield same return as market return.
26.
Particulars of Securities Cost ` Dividend Capital gain
Gold Ltd. 10,000 1,725 −200
Silver Ltd. 15,000 1,000 1,200
Bronz Ltd. 14,000 700 6,000

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 PORTFOLIO MANAGEMENT 6.113
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GOI Bonds 36,000 3,600 −1,500

Total 75,000 7,025 5,500

Expected rate of return on market portfolio

Dividend Earned + Capital appreciation
× 100
Initial investment
` 7,025 + ` 5,500
= × 100 = 16.7%
` 75,000

Risk free return

0.6 + 0.8 + 0.6 + 0.01
Average of Betas = = Average of Betas* = 0.50
4

Average return = Risk free return + Average Betas (Expected return – Risk free return)

15.7 = Risk free return + 0.50 (16.7 – Risk free return)

Risk free return = 14.7%

* Alternatively, it can also be calculated through Weighted Average Beta.

Expected Rate of Return for each security is
Rate of Return = Rf + B (Rm – Rf)
Gold Ltd. = 14.7 + 0.6 (16.7 – 14.7) = 15.90%
Silver Ltd. = 14.7 + 0.8 (16.7 – 14.7) = 16.30%
Bronz Ltd. = 14.7 + 0.6 (16.7 – 14.7) = 15.90%
GOI Bonds = 14.7 + 0.01 (16.7 – 14.7) = 14.72%

* Alternatively, it can also be computed as follows:

Particulars of Cost Market Dividend Capital Beta
Securities ` price ` ` Gain `
(1) (2) (3) (4) (5) (6) (3) x (6)
Gold Ltd. 10,000 9,800 1,725 −200 0.6 5,880
Silver Ltd. 15,000 16,200 1,000 1,200 0.8 12,960
Bronz Ltd. 14,000 20,000 700 6,000 0.6 12,000
GOI Bonds 36,000 34,500 3,600 −1,500 0.01 345
Total 75,000 80,500 7,025 5,500 31,185

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31,185
β of the Portfolio = = 0.387
80,500

Using GOI Bond we can compute Risk Free Rate of Return as follows:
(34,500- 36,000)+ 3,600
Rf = = 0.0583 i.e. 5.83%
36,000

Now we can calculate Market Return (Rm) using average return of the portfolio as follows:
Rp = Rf + β(Rm - R f)
15.7% = 5.83% + 0.387(Rm – 5.83%)

27. (i) Expected rate of return

Total Investments Dividends Capital Gains
Epsilon Ltd. 25 2 25
Sigma Ltd. 35 2 25
Omega Ltd. 45 2 90
GOI Bonds 1,000 140 _5
1,105 146 145
146 + 145
Expected Return on market portfolio= = 26.33%
1105
CAPM E(Rp) = RF + β [E(RM) – RF]

Epsilon Ltd 14+0.8 [26.33-14] = 14+9.86 = 23.86%

Sigma Ltd. 14+0.7 [26.33-14] = 14+8.63 = 22.63%
Omega Ltd. 14+0.5 [26.33-14] = 14+6.17 = 20.17%
GOI Bonds 14+0.01 [26.33-14] = 14+0.12 = 14.12%

(ii) Average Return of Portfolio

23.86 + 22.63 + 20.17 + 14.12 80.78
= = 20.20%
4 4
0.8 + 0.7 + 0.5 + 0.01 2.01
Alternatively, = = 0.5025
4 4

14 + 0.5025 (26.33 - 14) = 14+ 6.20 = 20.20%

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28. Calculation of expected return on market portfolio (Rm)

Investment Cost (`) Dividends (`) Capital Gains (` )
Shares X 8,000 800 200
Shares Y 10,000 800 500
Shares Z 16,000 800 6,000
PSU Bonds 34,000 3,400 –1,700
68,000 5,800 5,000
5,800 + 5,000
Rm = × 100 = 15.88%
68,000

Calculation of expected rate of return on individual security:

Security

Shares X 15 + 0.8 (15.88 – 15.0) = 15.70%

Shares Y 15 + 0.7 (15.88 – 15.0) = 15.62%
Shares Z 15 + 0.5 (15.88 – 15.0) = 15.44%
PSU Bonds 15 + 0.2 (15.88 – 15.0) = 15.18%

Calculation of the Average Return of the Portfolio:

15.70 + 15.62 + 15.44 + 15.18
= = 15.49%.
4
29. On the basis of existing and revised factors, rate of return and price of share is to be
calculated.
Existing rate of return
= R f + Beta (Rm – R f ) = 12% + 1.4 (6%) = 20.4%
Revised rate of return
= 10% + 1.25 (4%) = 15%
Price of share (original)
D (1 + g) 2 (1.05) 2.10
=Po = = = ` 13.63
Ke - g 0.204 - 0.05 0.154

Price of share (Revised)

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2 (1.09) 2.18
Po
= = = ` 36.33
0.15 - 0.09 0.06
In case of existing market price of ` 25 per share, rate of return (20.4%) and possible
equilibrium price of share at ` 13.63, this share needs to be sold because the share is
overpriced (` 25 – 13.63) by ` 11.37. However, under the changed scenario where growth of
dividend has been revised at 9% and the return though decreased at 15% but the possible
price of share is to be at ` 36.33 and therefore, in order to expect price appreciation to `
36.33 the investor should hold the shares, if other things remain the same
30. On the basis of existing and revised factors, rate of return and price of share is to be
calculated.
Existing rate of return
= Rf + Beta (Rm – Rf)
= 12% + 1.3 (5%) = 18.5%
Revised rate of return
= 10% + 1.4 (4%) = 15.60%
Price of share (original)
D (1 + g) 3 (1.09) 3.27
P = = = = ` 34.42
o K -g 0.185 - 0.09 0.095
e

Price of share (Revised)

2.50 (1.07) 2.675
P = = = ` 31.10
o 0.156 - 0.07 0.086

Market price of share of ` 40 is higher in comparison to current equilibrium price of ` 34.42

and revised equity price of ` 31.10. Under this situation investor should sell the share.
31. (i) Investment committed to each security would be:-

A B C Total
(`) (`) (`) (`)
Portfolio X 1,500 2,000 1,500 5,000
Portfolio Y 600 1,500 900 3,000
Combined Portfolio 2,100 3,500 2,400 8,000
∴ Stock weights 0.26 0.44 0.30

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 PORTFOLIO MANAGEMENT 6.117
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(ii) The equation of critical line takes the following form:-

WB = a + bWA
Substituting the values of WA & WB from portfolio X and Y in above equation, we get
0.40 = a + 0.30b, and
0.50 = a + 0.20b
Solving above equation we obtain the slope and intercept, a = 0.70 and b= -1 and thus,
the critical line is
WB = 0.70 – WA
If half of the funds is invested in security A then,
WB = 0.70 – 0.50 = 0.20
Since WA + WB + WC = 1
WC = 1 - 0.50 – 0.20 = 0.30
∴ Allocation of funds to security B = 0.20 x 8,000 = ` 1,600, and
Security C = 0.30 x 8,000 = ` 2,400

32. Workings:

Calculation of return on portfolio for 2009-10 (Calculation in

` / share)
M N
Dividend received during the year 10 3
Capital gain/loss by 31.03.10
Market value by 31.03.10 220 290
Cost of investment 200 300
Gain/loss 20 (-)10
Yield 30 (-)7
Cost 200 300
% return 15% (-)2.33%
Weight in the portfolio 57 43
Weighted average return 7.55%
Calculation of estimated return for 2010-11

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Expected dividend 20 3.5

Capital gain by 31.03.11
(220x0.2)+ (250x0.5)+(280x0.3) – 220=(253-220) 33 -
(290x0.2)+(310x0.5)+(330x0.3) – 290= (312 – 290) - 22
Yield 53 25.5
*Market Value 01.04.10 220 290
% return 24.09% 8.79%
*Weight in portfolio (1,000x220): (500x290) 60.3 39.7
Weighted average (Expected) return 18.02%
(*The market value on 31.03.10 is used as the base
for calculating yield for 10-11)

(i) Average Return from Portfolio for the year ended 31.03.2010 is 7.55%.
(ii) Expected Average Return from portfolio for the year 2010-11 is 18.02%
(iii) Calculation of Standard Deviation
M Ltd.
Exp. Exp. Exp. Exp Prob. (1) Dev. Square (2) X (3)
market gain div. Yield Factor X(2) of dev.
value (PM - PM )
(1) (2) (3)
220 0 20 20 0.2 4 -33 1089 217.80
250 30 20 50 0.5 25 -3 9 4.50
280 60 20 80 0.3 24 27 729 218.70
53 σ2M =
441.00

Standard Deviation (σM) 21

N Ltd.
Exp. Exp. Exp. Exp Prob. (1) Dev. Square (2) X (3)
market gain div. Yield Factor X(2) of dev.
value (PN- PN )
(1) (2) (3)
290 0 3.5 3.5 0.2 0.7 -22 484 96.80
310 20 3.5 23.5 0.5 11.75 -2 4 2.00
330 40 3.5 43.5 0.3 13.05 18 324 97.20
25.5 σ2N = 196.00

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 PORTFOLIO MANAGEMENT 6.119
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Standard Deviation (σN) 14

Alternatively based on return in percentage terms Standard Deviation can also be
computed as follows:
M Ltd.
Exp. Exp. Exp. Exp Prob. (1) Dev. Square (2) X (3)
market gain div. Return Factor X(2) (PM - of dev.
value (2) (3)
(1) PM )
220 0 20 9.09 0.2 1.82 -15.01 225.30 45.06
250 30 20 22.73 0.5 11.37 -1.37 1.88 0.94
280 60 20 36.36 0.3 10.91 12.26 150.31 45.09
24.10 σ 2M = 91.09

Standard Deviation (σM) 9.54%

N Ltd.
Exp. Exp. Exp. Exp Prob. (1) X (2) Dev. Square (2) X (3)
market gain div. Return Factor of dev.
value (PN- PN )
(1) (2) (3)

290 0 3.5 1.21 0.2 0.24 -7.58 57.46 11.49

310 20 3.5 8.10 0.5 4.05 -0.69 0.48 0.24
330 40 3.5 15.00 0.3 4.50 6.21 38.56 11.57
8.79 σ2N =
23.30

Standard Deviation (σN) 4.83%

Share of company M Ltd. is more risky as the S.D. is more than company N Ltd.

∑ PA
i=G,S,R i i
33. Expected Return on stock A = E (A) =

(G,S & R, denotes Growth, Stagnation and Recession )

(0.40)(25) + 0.30(10)+ 0.30(-5) = 11.5%

Expected Return on ‘B’
(0.40×20) + (0.30×15) +0.30× (-8)=10.1%

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Expected Return on Market index

(0.40 × 18) + (0.30 × 13) + 0.30 × (-3) =10.2%
Variance of Market index

(18 - 10.2)2 (0.40) + (13 - 10.2)2 (0.30) + (-3 - 10.2)2 (0.30)

= 24.34 + 2.35 + 52.27 = 78.96%
Covariance of stock A and Market Index M

Cov. (AM) = ∑ ([A - E(A)] [Mi - E(M)]Pi

i=G,S,R i
(25 -11.5) (18 - 10.2)(0.40) + (10 - 11.5) (13 - 10.2) (0.30) + (-5-11.5) (-3-10.2)(0.30)
= 42.12 + (-1.26) + 65.34=106.20
Covariance of stock B and Market index M
(20-10.1) (18-10.2)(0.40)+(15-10.1)(13-10.2)(0.30) + (-8-10.1)(-3-10.2)(0.30)= 30.89 + 4.12
+ 71.67=106.68
CoV(AM) 106.20
Beta for stock A = = = 1.345
VAR(M) 78.96

CoV(BM) 106.68
Beta for Stock B = = =1.351
VarM 78.96
Required Return for A
R (A) = Rf + β (M-Rf)
11% + 1.345(10.2 - 11) % = 9.924%
Required Return for B
11% + 1.351 (10.2 – 11) % = 9.92%
Alpha for Stock A
E (A) – R (A) i.e. 11.5 % – 9.924% = 1.576%
Alpha for Stock B
E (B) – R (B) i.e. 10.1% - 9.92% = 0.18%
Since stock A and B both have positive Alpha, therefore, they are underpriced. The investor
should make fresh investment in them.

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 PORTFOLIO MANAGEMENT 6.121
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34. (i) Portfolio Beta

0.20 x 0.40 + 0.50 x 0.50 + 0.30 x 1.10 = 0.66
(ii) Residual Variance
To determine Residual Variance first of all we shall compute the Systematic Risk as
follows:

β2A × σ M
2
= (0.40)2(0.01) = 0.0016

βB2 × σ M2 = (0.50)2(0.01) = 0.0025

β2C × σ M2 = (1.10)2(0.01) = 0.0121

Residual Variance
A 0.015 – 0.0016 = 0.0134
B 0.025 – 0.0025 = 0.0225
C 0.100 – 0.0121 = 0.0879
(iii) Portfolio variance using Sharpe Index Model
Systematic Variance of Portfolio = (0.10)2 x (0.66)2 = 0.004356

Unsystematic Variance of Portfolio = 0.0134 x (0.20)2 + 0.0225 x (0.50)2 + 0.0879 x

(0.30)2 = 0.014072
Total Variance = 0.004356 + 0.014072 = 0.018428
(iv) Portfolio variance on the basis of Markowitz Theory
2
= (wA x wAx σ A ) + (wA x wBxCovAB) + (wA x wCxCovAC) + (wB x wAxCovAB) + (wB x wBx
σ B2 ) + (wB x wCxCovBC) + (wC x wAxCovCA) + (wC x wBxCovCB) + (wC x wCx σ 2c )

= (0.20 x 0.20 x 0.015) + (0.20 x 0.50 x 0.030) + (0.20 x 0.30 x 0.020) + (0.20 x 0.50
x 0.030) + (0.50 x 0.50 x 0.025) + (0.50 x 0.30 x 0.040) + (0.30 x 0.20 x 0.020) + (0.30
x 0.50 x 0.040) + (0.30 x 0.30 x 0.10)
= 0.0006 + 0.0030 + 0.0012 + 0.0030 + 0.00625 + 0.0060 + 0.0012 + 0.0060 + 0.0090
= 0.0363

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35. Securities need to be ranked on the basis of excess return to beta ratio from highest to the
lowest.
Security Ri βi Ri - Rf Ri - Rf
βi
A 15 1.5 8 5.33
B 12 2 5 2.5
C 10 2.5 3 1.2
D 9 1 2 2
E 8 1.2 1 0.83
F 14 1.5 7 4.67

Ranked Table:

(R i - R f ) x β i N
(R i - R f ) x β i β i2 N
β i2
Security R i - R f βi σ 2
ei
σ 2 ei ∑
e=i σ 2 ei σ 2 ei
∑σ
e=i
2
ei
Ci

A 8 1.5 40 0.30 0.30 0.056 0.056 1.923

F 7 1.5 30 0.35 0.65 0.075 0.131 2.814
B 5 2 20 0.50 1.15 0.20 0.331 2.668
D 2 1 10 0.20 1.35 0.10 0.431 2.542
C 3 2.5 30 0.25 1.60 0.208 0.639 2.165
E 1 1.2 20 0.06 1.66 0.072 0.711 2.047

CA = 10 x 0.30 / [1 + ( 10 x 0.056)] = 1.923

CF = 10 x 0.65 / [1 + ( 10 x 0.131)] = 2.814
CB = 10 x 1.15 / [1 + ( 10 x 0.331)] = 2.668
CD = 10 x 1.35 / [1 + ( 10 x 0.431)] = 2.542
CC = 10 x 1.60 / [1 + ( 10 x 0.639)] = 2.165
CE = 10 x 1.66 / [1 + ( 10 x 0.7111)] = 2.047
Cut off point is 2.814

Z = i 
[ i
(
β   R - R
f
- C]
)
 
 
i 2 
σ ei   β  
 i 
1.5
ZA = ( 5.33 - 2.814) = 0.09435
40

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 PORTFOLIO MANAGEMENT 6.123
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1.5
Z = ( 4.67 - 2.814) = 0.0928
F 30

X = 0.09435 / [ 0.09435 + 0.0928] = 50.41%

A

X = 0.0928 / [0.09435 + 0.0928] = 49.59%

F

Funds to be invested in security A & F are 50.41% and 49.59% respectively.

36. (i)
Security No. of Market Price (1) × (2) % to total (w) ß (x) wx
shares of Per Share
(1) (2)
VSL 10000 50 500000 0.4167 0.9 0.375
CSL 5000 20 100000 0.0833 1 0.083
SML 8000 25 200000 0.1667 1.5 0.250
APL 2000 200 400000 0.3333 1.2 0.400
1200000 1 1.108

Portfolio beta 1.108

(ii) Required Beta 0.8
It should become (0.8 / 1.108) 72.2 % of present portfolio
If ` 12,00,000 is 72.20%, the total portfolio should be
` 12,00,000 × 100/72.20 or ` 16,62,050
Additional investment in zero risk should be (` 16,62,050 – ` 12,00,000) = ` 4,62,050
Revised Portfolio will be
Security No. of Market Price (1) × (2) % to ß (x) wx
shares of Per Share total (w)
(1) (2)
VSL 10000 50 500000 0.3008 0.9 0.271
CSL 5000 20 100000 0.0602 1 0.060
SML 8000 25 200000 0.1203 1.5 0.180
APL 2000 200 400000 0.2407 1.2 0.289

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Risk free 46205 10 462050 0.2780 0 0

asset
1662050 1 0.800

(iii) To increase Beta to 1.2

Required beta 1.2

It should become 1.2 / 1.108 108.30% of present beta
If 1200000 is 108.30%, the total portfolio should be
1200000 × 100/108.30 or 1108033 say 1108030
Additional investment should be (-) 91967 i.e. Divest ` 91970 of Risk Free Asset
Revised Portfolio will be
Security No. of Market (1) × (2) % to total ß (x) wx
shares Price of Per (w)
(1) Share (2)
VSL 10000 50 500000 0.4513 0.9 0.406
CSL 5000 20 100000 0.0903 1 0.090
SML 8000 25 200000 0.1805 1.5 0.271
APL 2000 200 400000 0.3610 1.2 0.433
Risk free -9197 10 -91970 -0.0830 0 0
asset
1108030 1 1.20

Portfolio beta 1.20

Alternative Approach
(ii) Let x be the amount of Risk-Free Asset to be acquired, then
Security (1) × (2) ß (x) wx
VSL 500000 0.9 450000
CSL 100000 1 100000
SML 200000 1.5 300000
APL 400000 1.2 480000
Risk free asset x 0 0
1200000 + x 1330000

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 PORTFOLIO MANAGEMENT 6.125
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Accordingly,
13,30,000 = 0.8
12,00,000+ x

x = 462500 i.e. value of Risk Free Asset to be purchased to decrease beta of portfolio
to 0.8.

(iii) Similarly let y the amount of Risk Free Assets to be divest, then
13,30,000 = 1.20
12,00,000+ y

y = -91,667 i.e. value of Risk Free Asset to be divested to increase beta of portfolio to
1.20.
4
37. βp = ∑ xiβi
i=1

= 1.60 x 0.25 + 1.15 x 0.30 + 1.40 x 0.25 + 1.00 x 0.20

= 0.4 + 0.345 + 0.35 + 0.20 = 1.295
The Standard Deviation (Risk) of the portfolio is
= [(1.295)2(18)2+(0.25)2(7)2+(0.30)2(11)2+(0.25)2(3)2+(0.20)2(9)2)] ½
= [543.36 + 3.0625 + 10.89 + 0.5625 + 3.24] ½ = [561.115]½ = 23.69%

Alternative Answer
The variance of Security’s Return
σ2 = βi2 σ2m + σ2εi

Accordingly, variance of various securities

σ2 Weight(w) σ2Xw
L (1.60)2 (18)2 + 72 = 878.44 0.25 219.61
M (1.15)2 (18)2 + 112 = 549.49 0.30 164.85
N (1.40)2 (18)2 + 32 = 644.04 0.25 161.01
K (1.00)2 (18)2 + 92 = 405.00 0.20 81
Variance 626.47

SD = 626.47 = 25.03

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38. Return of the stock under APT

Factor Actual Expected Difference Beta Diff. х
value in % value in % Beta
GNP 7.70 7.70 0.00 1.20 0.00
Inflation 7.00 5.50 1.50 1.75 2.63
Interest rate 9.00 7.75 1.25 1.30 1.63
Stock index 12.00 10.00 2.00 1.70 3.40
Ind. Production 7.50 7.00 0.50 1.00 0.50
8.16
Risk free rate in % 9.25
Return under APT 17.41
V V
39. (i) β =β × E
+ B × D
asset equity V debt V
0 0

Note: Since βdebt is not given it is assumed that company debt capital is virtually
riskless.
If company’s debt capital is riskless than above relationship become:
VE
Here β equity = 1.5; β asset = β equity
VO
As βdebt = 0
VE = ` 60 lakhs.
VD = ` 40 lakhs.
V0 = ` 100 lakhs.

β asset = 1.5 × 60 lakhs

100 lakhs

= 0.9
(ii) (a) If only equity is used to finance the expansion, the Cost of Capital for
discounting company’s expansion of existing business shall be computed as
follows:
Company’s cost of equity = Rf + βA × Market Risk premium
Where Rf = Risk free rate of return
βA = Beta of company assets

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 PORTFOLIO MANAGEMENT 6.127
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Therefore, company’s cost of equity = 8% + 0.9 × 10 = 17% and overall cost of

capital shall be 17%.
(b) Alternatively, if funds expansion are raised for in same proportion as exiting
capital structure, then cost of capital shall be computed as follows:
Cost of Equity = 8% + 1.5 x 10 = 23%
Cost of Debt = 8%
3 2
WACC (Cost of Capital) = 23% × + 8% × = 17%
5 5

40. (a) Method I

Stock’s return
Small cap growth = 4.5 + 0.80 x 6.85 + 1.39 x (-3.5) + 1.35 x 0.65 = 5.9925%
Small cap value = 4.5 + 0.90 x 6.85 + 0.75 x (-3.5) + 1.25 x 0.65 = 8.8525%
Large cap growth = 4.5 + 1.165 x 6.85 + 2.75 x (-3.5) + 8.65 x 0.65 = 8.478%
Large cap value = 4.5 + 0.85 x 6.85 + 2.05 x (-3.5) + 6.75 x 0.65 = 7.535%
Expected return on market index
0.25 x 5.9925 + 0.10 x 8.8525 + 0.50 x 8.478 + 0.15 x 7.535 = 7.7526%
Method II
Expected return on the market index
= 4.5% + [0.1x0.9 + 0.25x0.8 + 0.15x0.85 + 0.50x1.165] x 6.85 + [(0.75 x 0.10 +
1.39 x 0.25 + 2.05 x 0.15 + 2.75 x 0.5)] x (-3.5) + [{1.25 x 0.10 + 1.35 x 0.25 +
6.75 x 0.15 + 8.65 x 0.50)] x 0.65
= 4.5 + 6.85 + (-7.3675) + 3.77 = 7.7525%.
(b) Using CAPM,
Small cap growth = 4.5 + 6.85 x 0.80 = 9.98%
Small cap value = 4.5 + 6.85 x 0.90 = 10.665%
Large cap growth = 4.5 + 6.85 x 1.165 = 12.48%
Large cap value = 4.5 + 6.85 x 0.85 = 10.3225%
Expected return on market index
= 0.25 x 9.98 + 0.10 x 10.665 + 0.50 x 12.45 + 0.15 x 10.3225 = 11.33%

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(c) Let us assume that Mr. Nirmal will invest X1% in small cap value stock and X2% in
large cap growth stock
X1 + X2 = 1
0.90 X1 + 1.165 X2 = 1
0.90 X1 + 1.165(1 – X1) = 1
0.90 X1 + 1.165 – 1.165 X1 = 1
0.165 = 0.265 X1
0.165
= X1
0.265
0.623 = X1, X2 = 0.377
62.3% in small cap value
37.7% in large cap growth.
41. Sharpe Ratio S = (Rp – Rf)/σp
Treynor Ratio T = (Rp – Rf)/βp
Where,
Rp = Return on Fund
Rf = Risk-free rate
σp = Standard deviation of Fund
βp = Beta of Fund
Reward to Variability (Sharpe Ratio)
Mutual Rp Rf Rp – Rf σp Reward to Ranking
Fund Variability
A 15 6 9 7 1.285 2
B 18 6 12 10 1.20 3
C 14 6 8 5 1.60 1
D 12 6 6 6 1.00 5
E 16 6 10 9 1.11 4

Reward to Volatility (Treynor Ratio)

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 PORTFOLIO MANAGEMENT 6.129
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Mutual Rp Rf Rp – Rf βp Reward to Ranking

Fund Volatility
A 15 6 9 1.25 7.2 2
B 18 6 12 0.75 16 1
C 14 6 8 1.40 5.71 5
D 12 6 6 0.98 6.12 4
E 16 6 10 1.50 6.67 3

42. Let portfolio standard deviation be σp

Market Standard Deviation = σm
Coefficient of correlation = r
σ pr
Portfolio beta (βp) =
σm

Required portfolio return (Rp) = Rf + βp (Rm – Rf)

Portfolio Beta Return from the portfolio (Rp) (%)

A 1.75 17.75
B 0.90 13.50
C 0.65 12.25
D 1.25 15.25
E 0.90 13.50

Portfolio Sharpe Method Treynor Method Jensen's Alpha

Ratio Rank Ratio Rank Ratio Rank
A 4.00 IV 5.71 V 1.25 V
B 3.00 V 6.67 IV 1.50 IV
C 7.50 I 9.23 I 2.75 II
D 4.25 III 6.80 III 2.25 III
E 4.50 II 9.00 II 3.60 I

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© The Institute of Chartered Accountants of India