Business Environment Portfolio
Management
Summary
The introduction and the implementation of portfolio management practice...
Business Environment Portfolio
Management
• Use the same practices and usages that the organization applies to any of its
...
Business Environment Portfolio
Management
Portfolio Management
Portfolio management involves deciding what assets to inclu...
Business Environment Portfolio
Management
Models
Some of the financial models used in the process of Valuation, stock sele...
Business Environment Portfolio
Management
Post-Modern Portfolio Theory
This article discusses in detail the application of...
Business Environment Portfolio
Management
Sortino ratio:-
The Sortino ratio measures returns adjusted for the target and d...
Business Environment Portfolio
Management
This ratio replaces the traditional Sharpe ratio as a means for ranking investme...
Business Environment Portfolio
Management
as Markowitz himself and William F. Sharpe, the other giant of MPT acknowledge,
...
Business Environment Portfolio
Management
Richard Roll's critique (1977) states that this is only a theoretical concept, a...
Business Environment Portfolio
Management
If correlation is less than zero, i.e., the assets are inversely correlated, the...
Business Environment Portfolio
Management
3. Portfolio Expected Return
A weighted average of individual assets' expected r...
Business Environment Portfolio
Management
7. Portfolio Management
The art and science of making decisions about investment...
Business Environment Portfolio
Management
The theory that holds that assets should be chosen on the basis of how they inte...
Business Environment Portfolio
Management
Asset Pricing
A rational investor would not invest in an asset which does not im...
Business Environment Portfolio
Management
asset (and hence the return it will generate) should also be determined based on...
Business Environment Portfolio
Management
Securities Market Line
The SML essentially graphs the results from the capital a...
Business Environment Portfolio
Management
a security plotted below the SML is overvalued since the investor would be
accep...
Business Environment Portfolio
Management
Portfolio volatility is a function of the correlation of the component assets. T...
Business Environment Portfolio
Management
• Heuristic models
• Scoring techniques
• Visual or mapping techniques
The earli...
Business Environment Portfolio
Management
The chart shown above provides a graphical view of the project portfolio risk-
r...
Business Environment Portfolio
Management
project) as a basis for scoring or evaluating each project. An example of this
s...
Business Environment Portfolio
Management
Once the organization has its prioritized list of projects, it then needs to det...
Business Environment Portfolio
Management
Other factors can also be checked using bubble charts. For example, the risk-rew...
Business Environment Portfolio
Management
Finally, this balanced portfolio that has been developed is checked against the
...
Business Environment Portfolio
Management
Investment Managers And Portfolio Structures
At the heart of the investment mana...
Business Environment Portfolio
Management
because equities are riskier (more volatile) than bonds which are themselves mor...
Business Environment Portfolio
Management
the performance of each fund (and usually for internal purposes components of
ea...
Business Environment Portfolio
Management
successful active managers (measured before tax) may produce miserable after-tax...
Business Environment Portfolio
Management
is relative, as it evaluates portfolio performance in reference to a benchmark,
...
Business Environment Portfolio
Management
which factors are style indices. This model allows a custom benchmark for each
p...
Business Environment Portfolio
Management
CASE STUDY
Portfolio Management Theory and Technical Analysis
The Bill of Rights...
Business Environment Portfolio
Management
 The "INDIFFERENCE CURVE" or the "UTILITY CURVE"
 The OPTIMAL SOLUTION (=maxim...
Business Environment Portfolio
Management
Will spend $20,000 in year 1 plus lend money against his income in year 2.He wil...
Business Environment Portfolio
Management
 The Mean of the yields on two types of assets = The Sum of the Means of
each a...
Business Environment Portfolio
Management
Leena Rohela / MBA / Semester II 35.
Sr.no. State of investor Description Proper...
Business Environment Portfolio
Management
THE EFFICIENT MARKET
 Efficient Market: The price of the share reflects all ava...
Business Environment Portfolio
Management
Answer: No. On average, the investor will buy at equilibrium convergent
price.
...
Business Environment Portfolio
Management
 Random Walk Theory (RWT):
a. Current share prices are not dependent on yesterd...
Business Environment Portfolio
Management
Pa - Pa-1 = ( ED P + D P/ ED P ) · ( Pa-1-c - Pa-2-c + R ) Using a correlation
c...
Business Environment Portfolio
Management
Filter users and were identical with random players. This was proved by
using a ...
Business Environment Portfolio
Management
the beginning of the year but the excess yield will only cover transaction
costs...
Business Environment Portfolio
Management
a. Select your investments on economic grounds. Public knowledge is no
advantage...
Business Environment Portfolio
Management
4. The structure of a bond: principal (face), coupon;
5. Stripping and discounti...
Business Environment Portfolio
Management
2. Expenses Costs of goods sold I Operating expenses General and administrative
...
Business Environment Portfolio
Management
13. Abnormal stock returns are obtained where actual earnings deviate from
proje...
Business Environment Portfolio
Management
25. Factor 2 is the Interest burden ratio
26. Factor 5 is the Leverage ratio
27....
Business Environment Portfolio
Management
41. ROE = E / B = P/B / P/E
42. Earnings yield = E / P = ROE / P/B
43. The GAAP ...
Business Environment Portfolio
Management
2. PAR VALUE (=Face Value) COUPON (=Interest payment)
3. The PRESENT VALUE (=the...
Business Environment Portfolio
Management
7. BOND EQUIVALENT YIELD (BEY) = PAR-Pb / Pb ´365 / n
8. BEY = 365 ´ BDY / 360 -...
Business Environment Portfolio
Management
EARNINGS / TOTAL ASSETS + 1,2 times WORKING CAPITAL /
TOTAL ASSETS
MACRO ECONOMY...
Business Environment Portfolio
Management
MANAGING BOND PORTFOLIOS
1. Return On Investment (ROI) = Interest + Capital Gain...
Business Environment Portfolio
Management
c. When the coupon rate is constant, a bond's duration increases with its time t...
Business Environment Portfolio
Management
13. Fixed income investors face two types of risks: Price risk Reinvestment (of ...
Business Environment Portfolio
Management
d. Pure yield pickup swap - holding higher yield bond.
e. Tax swap - intended to...
Business Environment Portfolio
Management
INTEREST RATE SWAPS
1. Between two parties exposed to opposite types of interest...
Business Environment Portfolio
Management
1. Capital Asset Pricing Model (CAPM) predicts the relationship between an asset...
Business Environment Portfolio
Management
d. The risk premium on an individual asset will be proportional to the risk
prem...
Business Environment Portfolio
Management
6. Return Beta 1/2 1 2 Investment with Beta 1/2 should earn 50% of the market's
...
Business Environment Portfolio
Management
TECHNICAL ANALYSIS
Part A
 Efficient market hypothesis - share prices reflect a...
Business Environment Portfolio
Management
® cycles (Kondratieff)
 Elton - Gruber experiments with series of random number...
Business Environment Portfolio
Management
TECHNICAL ANALYSIS - Part B
 Versus fundamental: dynamic (trend) vs. static (va...
Business Environment Portfolio
Management
average line predicts future prices Relative strength - compares performance
of ...
Business Environment Portfolio
Management
 Expanding configurations Price fluctuations so that price peaks and troughs
ca...
Business Environment Portfolio
Management
 The penetration of a steep trendline is less meaningful and the trend will
pre...
Business Environment Portfolio
Management
 Weighted MA (2nd version) Multiplication of each datum by its serial
number.
...
Business Environment Portfolio
Management
 Relative strength Does not indicate direction - only strength of movement.
Mor...
Business Environment Portfolio
Management
%D smoothed using same method
6. Stochastic trading signals:
a. Divergence
 Bul...
Business Environment Portfolio
Management
12. Open Interest Number of contract held by buyers or owed by short sellers in ...
Business Environment Portfolio
Management
of return, benefits and needed outcomes, and associated risks. And, this is why ...
Business Environment Portfolio
Management
business goals (i.e., they diversify investment risk). They must also manage the...
Business Environment Portfolio
Management
reference a portion of the organizational IT practices that deals with "Commerci...
Business Environment Portfolio
Management
practices is to survey the current state of these enabling capabilities and to m...
Business Environment Portfolio
Management
In this rather simple (and not very realistic example) one element (among many!)...
Business Environment Portfolio
Management
organizational entities, individual roles, and also its goals, and functions, in...
Portfolio management
Portfolio management
Portfolio management
Portfolio management
Portfolio management
Portfolio management
Portfolio management
Portfolio management
Portfolio management
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Portfolio management

  1. 1. Business Environment Portfolio Management Summary The introduction and the implementation of portfolio management practices into the organization is a significant undertaking. The potential value it offers is present in multiple dimensions: achievement of goals and goals components of the business strategy and direction, better overall oversight and control of initiatives, improved application and targeting of all resources (human, financial, technical) to the real needs of the organization and the delivery of value. As with any significant undertaking, there is a need for well-understood risk management to improve the chance of success. I believe that understanding and addressing these four key points will assist in prudent risk-taking, as well as improve the likelihood of success in the introduction and implementation of portfolio management practices into the organization. To recap, these points are: • Understand what type of work effort the introduction and implementation of portfolio management practices is, in order to identify an effective approach; and, also to identify which capabilities and experience within your organization (or outside it) you will require. • Assess and understand the existing capabilities within the organization which will be required to enable and sustain the exercise of portfolio management practices; and, determine if a state of "readiness" exists to move ahead with its introduction and implementation. • Introduce the set of portfolio management practices in stages. However, you must understand and agree on the most urgent needs and/or the most potential value, and then implement the sub-set of practices which will most directly address these. Leena Rohela / MBA / Semester II 1.
  2. 2. Business Environment Portfolio Management • Use the same practices and usages that the organization applies to any of its significant initiatives, because the introduction and implementation of portfolio management practices is a significant initiative. PORTFOLIO The art and science of making decisions about investment mix and policy, matching investments to objectives, asset allocation for individuals and institutions, and balancing risk vs. performance. Notes: Portfolio management is all about strengths, weaknesses, opportunities, and threats in the choice of debt vs. equity, domestic vs. international, growth vs. safety, and numerous other trades-offs encountered in the attempt to maximize return at a given appetite for risk. In finance, a portfolio is an appropriate mix of or collection of investments held by an institution or a private individual. In building up an investment portfolio a financial institution will typically conduct its own investment analysis, whilst a private individual may make use of the services of a financial advisor or a financial institution which offers portfolio management services. Holding a portfolio is part of an investment and risk-limiting strategy called diversification. By owning several assets, certain types of risk (in particular specific risk) can be reduced. The assets in the portfolio could include stocks, bonds, options, warrants, gold certificates, real estate, futures contracts, production facilities, or any other item that is expected to retain its value. Leena Rohela / MBA / Semester II 2.
  3. 3. Business Environment Portfolio Management Portfolio Management Portfolio management involves deciding what assets to include in the portfolio, given the goals of the portfolio owner and changing economic conditions. Selection involves deciding what assets to purchase, how many to purchase, when to purchase them, and what assets to divest. These decisions always involve some sort of performance measurement, most typically expected return on the portfolio, and the risk associated with this return (i.e. the standard deviation of the return). Typically the expected returns from portfolios comprised of different asset bundles are compared. The unique goals and circumstances of the investor must also be considered. Some investors are more risk averse than others. Mutual fund has developed particular techniques to optimize their portfolio holdings. See fund management for details. Portfolio Formation Many strategies have been developed to form a portfolio. • Precision weighted portfolio • Equally-weighted portfolio • Capitalization-weighted portfolio • Price-weighted portfolio Optimal portfolio (for which the Sharpe ratio is highest) Leena Rohela / MBA / Semester II 3.
  4. 4. Business Environment Portfolio Management Models Some of the financial models used in the process of Valuation, stock selection, and management of portfolios include: Modern Portfolio Theory Capital Market Line Modern portfolio theory (MPT) proposes how rational investors will use diversification to optimize their portfolios, and how a risky asset should be priced. The basic concepts of the theory are Markowitz diversification, the efficient frontier, capital asset pricing model, the alpha and beta coefficients, the Capital Market Line and the Securities Market Line. MPT models an asset's return as a random variable, and models a portfolio as a weighted combination of assets; the return of a portfolio is thus the weighted combination of the assets' returns. Moreover, a portfolio's return is a random variable, and consequently has an expected value and a variance. Risk, in this model, is the standard deviation of the portfolio's return. Leena Rohela / MBA / Semester II 4.
  5. 5. Business Environment Portfolio Management Post-Modern Portfolio Theory This article discusses in detail the application of post-modern portfolio theory (PMPT) to risk/return analysis and describes its theoretical and practical benefits over modern portfolio theory (“MPT”), also referred to as Mean-Variance Analysis (“MVA”). And like MPT, PMPT proposes how rational investors will use diversification to optimize their portfolios, and how a risky asset should be priced Leena Rohela / MBA / Semester II 5.
  6. 6. Business Environment Portfolio Management Sortino ratio:- The Sortino ratio measures returns adjusted for the target and downside risk. It is defined as where, r = the annualized rate of return, t = the target return, d = downside risk. Leena Rohela / MBA / Semester II 6. Index Sortino ratio Sharpe ratio 90-day T-bill -1.00 0.00 Lehman Aggregate -0.29 0.63 MSCI EAFE -0.05 0.30 Russell 2000 0.55 0.93 S&P 500 0.84 1.25
  7. 7. Business Environment Portfolio Management This ratio replaces the traditional Sharpe ratio as a means for ranking investment results. The following table shows risk-adjusted ratios for several major indexes using both Sortino and Sharpe ratios. The data cover the five years 1992-1996 and are based on monthly total returns. The Sortino ratio is calculated against a 9.0% target As an example of the different conclusions that can be drawn using these two ratios, notice how the Lehman Aggregate and MSCI EAFE compare - the Lehman ranks higher using the Sharpe ratio whereas EAFE ranks higher using the Sortino ratio. In many cases, manager or index rankings will be different, depending on the risk-adjusted measure used. These patterns will change again for different values of t. For example, when t is close to the risk-free rate, the Sortino Ratio for T-Bill's will be higher than that for the S&P 500, while the Sharpe ratio remains unchanged. Overview It has been a generation since Harry Markowitz laid the foundations and built much of the structure of what we now know as MPT, the greatest contribution of which is the establishment of a formal risk/return framework for investment decision- making. By defining investment risk in quantitative terms, Markowitz gave investors a mathematical approach to asset selection and portfolio management. But Leena Rohela / MBA / Semester II 7.
  8. 8. Business Environment Portfolio Management as Markowitz himself and William F. Sharpe, the other giant of MPT acknowledge, there are important limitations to the original MPT formulation. "Under certain conditions the MVA can be shown to lead to unsatisfactory predictions of (investor) behavior. Markowitz suggests that a model based on the semi-variance would be preferable; in light of the formidable computational problems, however, he bases his (MVA) analysis on the mean and the standard deviation." The causes of these “unsatisfactory” aspects of MPT are the assumptions that 1) variance of portfolio returns is the correct measure of investment risk, and 2) the investment returns of all securities and portfolios can be adequately represented by the normal distribution. Stated another way, MPT is limited by measures of risk and return that do not always represent the realities of the investment markets. Recent advances in portfolio and financial theory, coupled with today’s increased electronic computing power, have overcome these limitations. The resulting expanded risk/return paradigm is known as Post-Modern Portfolio Theory, or PMPT. Thus, MPT becomes nothing more than a (symmetrical) special case of PMPT. Market portfolio A Market Portfolio is a portfolio consisting of a weighted sum of every asset in the market, with weights in the proportions that they exist in the market (with the necessary assumption that these assets are infinitely divisible). Leena Rohela / MBA / Semester II 8.
  9. 9. Business Environment Portfolio Management Richard Roll's critique (1977) states that this is only a theoretical concept, as to create a market portfolio for investment purposes in practice would necessarily include every single possible available asset, including real estate, precious metals, stamp collections, jewelry, and anything with any worth, as the theoretical market being referred to would be the world market. As a result, proxies for the market (such as the FTSE100 in the UK or the S&P500 in the US) are used in practice by investors. Roll's critique states that these proxies cannot provide an accurate representation of the entire market. The concept of a market portfolio plays an important role in many financial theories and models, including the Capital asset pricing model where it is the only fund in which investors need to invest, to be supplemented only by a risk-free asset (depending upon each investor's attitude towards risk). Portfolio Diversification An investor can reduce portfolio risk simply by holding instruments which are not perfectly correlated. In other words, investors can reduce their exposure to individual asset risk by holding a diversified portfolio of assets. Diversification will allow for the same portfolio return with reduced risk. If all the assets of a portfolio have a correlation of 1, i.e., perfect correlation, the portfolio volatility (standard deviation) will be equal to the weighted sum of the individual asset volatilities. Hence the portfolio variance will be equal to the square of the total weighted sum of the individual asset volatilities. If all the assets have a correlation of 0, i.e., perfectly uncorrelated, the portfolio variance is the sum of the individual asset weights squared times the individual asset variance (and volatility is the square root of this sum). Leena Rohela / MBA / Semester II 9.
  10. 10. Business Environment Portfolio Management If correlation is less than zero, i.e., the assets are inversely correlated, the portfolio variance and hence volatility will be less than if the correlation is 0. The lowest possible portfolio variance, and hence volatility, occurs when all the assets have a correlation of −1, i.e., perfect inverse correlation Portfolio diversification:- Investing in different asset classes and in securities of many issuers in an attempt to reduce overall investment risk and to avoid damaging a portfolio's performance by the poor performance of a single security, industry, (or country). 1. Portfolio Dressing The addition and deletion of securities by an institutional investor before a financial reporting period in order to make the portfolio appear acceptable to investors. Typically, portfolio dressing involves the sale of big losers and the addition of big gainers to convey the impression that the portfolio manager is competent. Also called dressing up a portfolio. 2. Portfolio Effect A reduction in the variation of returns on a combination of assets compared with the average of the variations of the individual assets. This effect measures the extent to which variations in returns on a portion of assets held are partially canceled by variations in returns on other assets held in the same portfolio. Leena Rohela / MBA / Semester II 10.
  11. 11. Business Environment Portfolio Management 3. Portfolio Expected Return A weighted average of individual assets' expected returns. 4. Portfolio Income Income from investments, including dividends, interest, royalties, and capital gains. There are three main categories of income: active income, passive income, and portfolio income. These categories of income are important because losses in passive income generally cannot be offset against active or portfolio income. 5. Portfolio Insurance  A method of hedging a portfolio of stocks against the market risk by short selling stock index futures.  Brokerage insurance such as the Securities Investor Protection Corporation (SIPC). Notes:  This hedging technique is frequently used by institutional investors when the market direction is uncertain or volatile. By short selling index futures they offset any downturns, but they also hinder any gains.  SIPC is an insurance that provides brokerage customers up to $500,000 coverage for cash and securities held by a firm. 6. Portfolio Internal Rate of Return The rate of return computed by first determining the cash flows for all the bonds in the portfolio and then finding the interest rate that will make the present value of the cash flows equal to the market value of the portfolio Leena Rohela / MBA / Semester II 11.
  12. 12. Business Environment Portfolio Management 7. Portfolio Management The art and science of making decisions about investment mix and policy, matching investments to objectives, asset allocation for individuals and institutions, and balancing risk vs. performance. Notes: Portfolio management is all about strengths, weaknesses, opportunities, and threats in the choice of debt vs. equity, domestic vs. international, growth vs. safety, and numerous other trade-offs encountered in the attempt to maximize return at a given appetite for risk 8. Portfolio Manager The person responsible for investing a mutual fund's assets, implementing its investment strategy, and managing the day-to-day portfolio trading. Notes: The portfolio manager is one of the most important factors to consider when looking at a mutual fund. 9. Portfolio Runoff A decrease in the value and size of portfolios investing in mortgages and mortgage- backed securities. Notes: This decrease occurs because of homeowners capitalizing on lowering interest rates through refinancing. The resulting effects usually mean lower revenues for the portfolio holders as the cash flow from mortgage interest decreases 10.Portfolio Theory Leena Rohela / MBA / Semester II 12.
  13. 13. Business Environment Portfolio Management The theory that holds that assets should be chosen on the basis of how they interact with one another rather than how they perform in isolation. According to this theory, an optimal combination would secure for the investor the highest possible return for a given level of risk or the least possible risk for a given level of return. Although individual investors can use some of the ideas of portfolio theory in putting together a group of investments, the theory and the literature relating to it are so complex and mathematically sophisticated that the theory is applied primarily by market professionals. Also called modern portfolio theory. 11.Portfolio Transaction Costs The expenses associated with buying and selling securities, including commissions, purchase and redemption fees, exchange fees, and other miscellaneous costs. In a mutual fund prospectus, these expenses are listed separately from the fund's expense ratio. Risks The model assumes that investors are risk adverse, meaning that given two assets that offer the same expected return, investors will prefer the less risky one. Thus, an investor will take on increased risk only if compensated by higher expected returns. Conversely, an investor who wants higher returns must accept more risk. The exact trade-off will differ by investor based on individual risk aversion characteristics. The implication is that a rational investor will not invest in a portfolio if a second portfolio exists with a more favorable risk-return profile – i.e., if for that level of risk an alternative portfolio exists which has better expected returns. Leena Rohela / MBA / Semester II 13.
  14. 14. Business Environment Portfolio Management Asset Pricing A rational investor would not invest in an asset which does not improve the risk- return characteristics of his existing portfolio. Since a rational investor would hold the market portfolio, the asset in question will be added to the market portfolio. MPT derives the required return for a correctly priced asset in this context. Systematic Risk And Specific Risk Specific risk is the risk associated with individual assets - within a portfolio these risks can be reduced through diversification (specific risks "cancel out"). Specific risk is also called diversifiable, unique, unsystematic, or idiosyncratic risk. Systematic risk (a.k.a. portfolio risk or market risk) refers to the risk common to all securities - except for selling short as noted below, systematic risk cannot be diversified away (within one market). Within the market portfolio, asset specific risk will be diversified away to the extent possible. Systematic risk is therefore equated with the risk (standard deviation) of the market portfolio. Since a security will be purchased only if it improves the risk / return characteristics of the market portfolio, the risk of a security will be the risk it adds to the market portfolio. In this context, the volatility of the asset, and its correlation with the market portfolio, is historically observed and is therefore a given (there are several approaches to asset pricing that attempt to price assets by modelling the stochastic properties of the moments of assets' returns - these are broadly referred to as conditional asset pricing models). The (maximum) price paid for any particular Leena Rohela / MBA / Semester II 14.
  15. 15. Business Environment Portfolio Management asset (and hence the return it will generate) should also be determined based on its relationship with the market portfolio. Systematic risks within one market can be managed through a strategy of using both long and short positions within one portfolio, creating a "market neutral" portfolio. Security Characteristic Line The Security Characteristic Line (SCL) represents the relationship between the market return (rM) and the return ri of a given asset i at a given time t. In general, it is reasonable to assume that the SCL is a straight line and can be illustrated as a statistical equation: Where αi is called the asset's alpha coefficient and βi the asset's beta coefficient. Capital Asset Pricing Model The asset return depends on the amount for the asset today. The price paid must ensure that the market portfolio's risk / return characteristics improve when the asset is added to it. The CAPM is a model which derives the theoretical required return (i.e., discount rate) for an asset in a market, given the risk-free rate available to investors and the risk of the market as a whole. Leena Rohela / MBA / Semester II 15.
  16. 16. Business Environment Portfolio Management Securities Market Line The SML essentially graphs the results from the capital asset pricing model (CAPM) formula. The x-axis represents the risk (beta), and the y-axis represents the expected return. The market risk premium is determined from the slope of the SML. The relationship between β and required return is plotted on the securities market line (SML) which shows expected return as a function of β. The intercept is the risk-free rate available for the market, while the slope is E(Rm − Rf). The securities market line can be regarded as representing a single-factor model of the asset price, where Beta is exposure to changes in value of the Market It is a useful tool in determining if an asset being considered for a portfolio offers a reasonable expected return for risk. Individual securities are plotted on the SML graph. If the security's risk versus expected return is plotted above the SML, it is undervalued since the investor can expect a greater return for the inherent risk. And Leena Rohela / MBA / Semester II 16.
  17. 17. Business Environment Portfolio Management a security plotted below the SML is overvalued since the investor would be accepting less return for the amount of risk assumed. Future  Mean and Variance It is further assumed that investor's risk / reward preference can be described via a quadratic utility function. The effect of this assumption is that only the expected return and the volatility (i.e. mean return and standard deviation) matter to the investor. The investor is indifferent to other characteristics of the distribution of returns, such as its skew (measures the level of asymmetry in the distribution) or kurtosis (measure of the thickness or socalled "fat tail"). This seems not to be true given the skeweness' risk seems to be priced by the market. Note that the theory uses a historical parameter, volatility, as a proxy for risk, while return is an expectation on the future. This is in line with the Efficiency Hypothesis and most of the classical finding in Finance such as Black and Scholes European Option Pricing (Martingale Measure: shortly speaking means that the best forecast for tomorrow is the price of today) Recent innovations in portfolio theory, particularly under the rubric of Post-Modern Portfolio Theory (PMPT), have exposed many flaws in this total reliance on standard deviation as the investor's risk proxy.  Under The Model Portfolio return is the proportion-weighted combination of the constituent assets' returns. Leena Rohela / MBA / Semester II 17.
  18. 18. Business Environment Portfolio Management Portfolio volatility is a function of the correlation of the component assets. The change in volatility is non-linear as the weighting of the component assets changes. A PRACTICAL APPROACH TO PORTFOLIO MANAGEMENT Portfolio Management is used to select a portfolio of new product development projects to achieve the following goals: • Maximize the profitability or value of the portfolio • Provide balance • Support the strategy of the enterprise Portfolio Management is the responsibility of the senior management team of an organization or business unit. This team, which might be called the Product Committee, meets regularly to manage the product pipeline and make decisions about the product portfolio. Often, this is the same group that conducts the stage- gate reviews in the organization. A logical starting point is to create a product strategy - markets, customers, products, strategy approach, competitive emphasis, etc. The second step is to understand the budget or resources available to balance the portfolio against. Third, each project must be assessed for profitability (rewards), investment requirements (resources), risks, and other appropriate factors. The weighting of the goals in making decisions about products varies from company. But organizations must balance these goals: risk vs. profitability, new products vs. improvements, strategy fit vs. reward, market vs. product line, long- term vs. short-term. Several types of techniques have been used to support the portfolio management process: Leena Rohela / MBA / Semester II 18.
  19. 19. Business Environment Portfolio Management • Heuristic models • Scoring techniques • Visual or mapping techniques The earliest Portfolio Management techniques optimized projects' profitability or financial returns using heuristic or mathematical models. However, this approach paid little attention to balance or aligning the portfolio to the organization's strategy. Scoring techniques weight and score criteria to take into account investment requirements, profitability, risk and strategic alignment. The shortcoming with this approach can be an over emphasis on financial measures and an inability to optimize the mix of projects. Mapping techniques use graphical presentation to visualize a portfolio's balance. These are typically presented in the form of a two-dimensional graph that shows the trade-off's or balance between two factors such as risks vs. profitability, marketplace fit vs. product line coverage, financial return vs. probability of success, etc. Leena Rohela / MBA / Semester II 19.
  20. 20. Business Environment Portfolio Management The chart shown above provides a graphical view of the project portfolio risk- reward balance. It is used to assure balance in the portfolio of projects - either too risky or conservative and appropriate levels of reward for the risk involved. The horizontal axis is Net Present Value; the vertical axis is Probability of Success. The size of the bubble is proportional to the total revenue generated over the lifetime sales of the product. While this visual presentation is useful, it can't prioritize projects. Therefore, some mix of these techniques is appropriate to support the Portfolio Management Process. This mix is often dependent upon the priority of the goals. Our recommended approach is to start with the overall business plan that should define the planned level of R&D investment, resources (e.g., headcount, etc.), and related sales expected from new products. With multiple business units, product lines or types of development, we recommend a strategic allocation process based on the business plan. This strategic allocation should apportion the planned R&D investment into business units, product lines, markets, geographic areas, etc. It may also breakdown the R&D investment into types of development, e.g., technology development, platform development, new products, and grades/enhancements/line extensions, etc. Once this is done, then a portfolio listing can be developed including the relevant portfolio data. We favor use of the development productivity index (DPI) or scores from the scoring method. The development productivity index is calculated as follows: (Net Present Value x Probability of Success) / Development Cost Remaining. It factors the NPV by the probability of both technical and commercial success. By dividing this result by the development cost remaining, it places more weight on projects nearer completion and with lower uncommitted costs. The scoring method uses a set of criteria (potentially different for each stage of the Leena Rohela / MBA / Semester II 20.
  21. 21. Business Environment Portfolio Management project) as a basis for scoring or evaluating each project. An example of this scoring method is shown with the worksheet below. Weighting factors can be set for each criterion. The evaluators on a Product Committee score projects (1 to 10, where 10 are best). The worksheet computes the average scores and applies the weighting factors to compute the overall score. The maximum weighted score for a project is 100. This portfolio list can then be ranked by either the development priority index or the score. An example of the portfolio list is shown below and the second illustration shows the category summary for the scoring method. Leena Rohela / MBA / Semester II 21.
  22. 22. Business Environment Portfolio Management Once the organization has its prioritized list of projects, it then needs to determine where the cutoff is based on the business plan and the planned level of investment of the resources available. This subset of the high priority projects then needs to be further analyzed and checked. The first step is to check that the prioritized list reflects the planned breakdown of projects based on the strategic allocation of the business plan. Pie charts such as the one below can be used for this purpose. Leena Rohela / MBA / Semester II 22.
  23. 23. Business Environment Portfolio Management Other factors can also be checked using bubble charts. For example, the risk-reward balance is commonly checked using the bubble chart shown earlier. A final check is to analyze product and technology roadmaps for project relationships. For example, if a lower priority platform project was omitted from the portfolio priority list, the subsequent higher priority projects that depend on that platform or platform technology would be impossible to execute unless that platform project were included in the portfolio priority list. An example of a roadmap is shown below. Leena Rohela / MBA / Semester II 23.
  24. 24. Business Environment Portfolio Management Finally, this balanced portfolio that has been developed is checked against the business plan as shown below to see if the plan goals have been achieved - projects within the planned R&D investment and resource levels and sales that have met the goals. With the significant investments required to develop new products and the risks involved, Portfolio Management is becoming an increasingly important tool to make strategic decisions about product development and the investment of company resources. In many companies, current year revenues are increasingly based on new products developed in the last one to three years. Therefore, these portfolio decisions are the basis of a company's profitability and even its continued existence over the next several years. Work of the Portfolio Manager Our Portfolio Managers are among a select group of Financial Advisors, whose qualifications are based on experience and commitment to client service. Each portfolio in the Portfolio Management Group is individually managed and designed to meet your unique needs. Benefits of the PM program: • Customized investment management • Personalized client service • Diversification • Resources of an industry leader addressing your individual needs • Unified fee structure Leena Rohela / MBA / Semester II 24.
  25. 25. Business Environment Portfolio Management Investment Managers And Portfolio Structures At the heart of the investment management industry are the managers who invest and divest client investments. A certified company investment advisor should conduct an assessment of each client's individual needs and risk profile. The advisor then recommends appropriate investments. Asset Allocation The different asset classes are stocks, bonds, real-estate and commodities. The exercise of allocating funds among these assets (and among individual securities within each asset class) is what investment management firms are paid for. Asset classes exhibit different market dynamics, and different interaction effects; thus, the allocation of monies among asset classes will have a significant effect on the performance of the fund. Some research suggests that allocation among asset classes has more predictive power than the choice of individual holdings in determining portfolio return. Arguably, the skill of a successful investment manager resides in constructing the asset allocation, and separately the individual holdings, so as to outperform certain benchmarks (e.g., the peer group of competing funds, bond and stock indices). Long-Term Returns It is important to look at the evidence on the long-term returns to different assets, and to holding period returns (the returns that accrue on average over different lengths of investment). For example, over very long holding periods (eg. 10+ years) in most countries, equities have generated higher returns than bonds, and bonds have generated higher returns than cash. According to financial theory, this is Leena Rohela / MBA / Semester II 25.
  26. 26. Business Environment Portfolio Management because equities are riskier (more volatile) than bonds which are themselves more risky than cash. Diversification Against the background of the asset allocation, fund managers consider the degree of diversification that makes sense for a given client (given its risk preferences) and construct a list of planned holdings accordingly. The list will indicate what percentage of the fund should be invested in each particular stock or bond. The theory of portfolio diversification was originated by Markowitz and effective diversification requires management of the correlation between the asset returns and the liability returns, issues internal to the portfolio (individual holdings volatility), and cross-correlations between the returns. Investment Styles There are a range of different styles of fund management that the institution can implement. For example, growth, value, market neutral, small capitalisation, indexed, etc. Each of these approaches has its distinctive features, adherents and, in any particular financial environment, distinctive risk characteristics. For example, there is evidence that growth styles (buying rapidly growing earnings) are especially effective when the companies able to generate such growth are scarce; conversely, when such growth is plentiful, then there is evidence that value styles tend to outperform the indices particularly successfully. Performance Measurement Fund performance is the acid test of fund management, and in the institutional context accurate measurement is a necessity. For that purpose, institutions measure Leena Rohela / MBA / Semester II 26.
  27. 27. Business Environment Portfolio Management the performance of each fund (and usually for internal purposes components of each fund) under their management, and performance is also measured by external firms that specialize in performance measurement. The leading performance measurement firms (e.g. Frank Russell in the USA) compile aggregate industry data, e.g., showing how funds in general performed against given indices and peer groups over various time periods. In a typical case (let us say an equity fund), then the calculation would be made (as far as the client is concerned) every quarter and would show a percentage change compared with the prior quarter (e.g., +4.6% total return in US dollars). This figure would be compared with other similar funds managed within the institution (for purposes of monitoring internal controls), with performance data for peer group funds, and with relevant indices (where available) or tailor-made performance benchmarks where appropriate. The specialist performance measurement firms calculate quartile and decile data and close attention would be paid to the (percentile) ranking of any fund. Generally speaking, it is probably appropriate for an investment firm to persuade its clients to assess performance over longer periods (e.g., 3 to 5 years) to smooth out very short term fluctuations in performance and the influence of the business cycle. This can be difficult however and, industry wide, there is a serious preoccupation with short-term numbers and the effect on the relationship with clients (and resultant business risks for the institutions). An enduring problem is whether to measure before-tax or after-tax performance. After-tax measurement represents the benefit to the investor, but investors' tax positions may vary. Before-tax measurement can be misleading, especially in regimens that tax realised capital gains (and not unrealised). It is thus possible that Leena Rohela / MBA / Semester II 27.
  28. 28. Business Environment Portfolio Management successful active managers (measured before tax) may produce miserable after-tax results. One possible solution is to report the after-tax position of some standard taxpayer. Risk-Adjusted Performance Measurement Performance measurement should not be reduced to the evaluation of fund returns alone, but must also integrate other fund elements that would be of interest to investors, such as the measure of risk taken. Several other aspects are also part of performance measurement: evaluating if managers have succeeded in reaching their objective, i.e. if their return was sufficiently high to reward the risks taken; how they compare to their peers; and finally whether the portfolio management results were due to luck or the manager’s skill. The need to answer all these questions has led to the development of more sophisticated performance measures, many of which originate in modern portfolio theory. Modern portfolio theory established the quantitative link that exists between portfolio risk and return. The Capital Asset Pricing Model (CAPM) developed by Sharpe (1964) highlighted the notion of rewarding risk and produced the first performance indicators, be they risk-adjusted ratios (Sharpe ratio, information ratio) or differential returns compared to benchmarks (alphas). The Sharpe ratio is the simplest and best known performance measure. It measures the return of a portfolio in excess of the risk-free rate, compared to the total risk of the portfolio. This measure is said to be absolute, as it does not refer to any benchmark, avoiding drawbacks related to a poor choice of benchmark. Meanwhile, it does not allow the separation of the performance of the market in which the portfolio is invested from that of the manager. The information ratio is a more general form of the Sharpe ratio in which the risk-free asset is replaced by a benchmark portfolio. This measure Leena Rohela / MBA / Semester II 28.
  29. 29. Business Environment Portfolio Management is relative, as it evaluates portfolio performance in reference to a benchmark, making the result strongly dependent on this benchmark choice. Portfolio alpha is obtained by measuring the difference between the return of the portfolio and that of a benchmark portfolio. This measure appears to be the only reliable performance measure to evaluate active management. In fact, we have to distinguish between normal returns, provided by the fair reward for portfolio exposure to different risks, and obtained through passive management, from abnormal performance (or outperformance) due to the manager’s skill, whether through market timing or stock picking. The first component is related to allocation and style investment choices, which may not be under the sole control of the manager, and depends on the economic context, while the second component is an evaluation of the success of the manager’s decisions. Only the latter, measured by alpha, allows the evaluation of the manager’s true performance. Portfolio normal return may be evaluated using factor models. The first model, proposed by Jensen (1968), relies on the CAPM and explains portfolio normal returns with the market index as the only factor. It quickly becomes clear, however, that one factor is not enough to explain the returns and that other factors have to be considered. Multi-factor models were developed as an alternative to the CAPM, allowing a better description of portfolio risks and an accurate evaluation of managers’ performance. For example, Fama and French (1993) have highlighted two important factors that characterise a company's risk in addition to market risk. These factors are the book-to-market ratio and the company's size as measured by its market capitalisation. Fama and French therefore proposed a three-factor model to describe portfolio normal returns. Carhart (1997) proposed to add momentum as a fourth factor to allow the persistence of the returns to be taken into account. Also of interest for performance measurement is Sharpe’s (1992) style analysis model, in Leena Rohela / MBA / Semester II 29.
  30. 30. Business Environment Portfolio Management which factors are style indices. This model allows a custom benchmark for each portfolio to be developed, using the linear combination of style indices that best replicate portfolio style allocation, and leads to an accurate evaluation of portfolio alpha. Education or Certification Increasingly, international business schools are incorporating the subject into their course outlines and some have formulated the title of 'Investment Management' conferred as specialist bachelors degrees (e.g. Cass Business School, London). Due to global cross-recognition agreements with the 2 major accrediting agencies AACSB and ACBSP which accredit over 560 of the best business school programs, the Certification of MFP Master Financial Planner Professional from the American Academy of Financial Management is available to AACSB and ACBSP business school graduates with finance or financial services-related concentrations. For people with aspirations to become an investment manager, further education may be needed beyond a bachelor in business, finance, or economics. A graduate degree or an investment qualification such as Chartered Financial Analyst (CFA) is needed to move up in the ranks of investment management. There is no evidence that any particular qualification enhances the most desirable characteristic of an investment manager, that is the ability to select investments that result in an above average (risk weighted) long-term performance. The industry has a tradition of seeking out, employing and generously rewarding such people without reference to any formal qualifications. Leena Rohela / MBA / Semester II 30.
  31. 31. Business Environment Portfolio Management CASE STUDY Portfolio Management Theory and Technical Analysis The Bill of Rights of the Investor  To earn a positive return (=yield) on their capital.  To insure his investments against risks (=to hedge).  To receive information identical to that of ALL other investors - complete, accurate and timely and to form independent judgement based on this information.  To alternate between investments - or be compensated for diminished liquidity.  To study how to carefully and rationally manage his portfolio of investments.  To compete on equal terms for the allocation of resources.  To assume that the market is efficient and fair. RISK  The difference between asset-owners, investors and speculators.  Income: general, free, current, projected (expectations), certain, uncertain.  CASE A (=pages 3 and 4)  The solutions to our FIRST DISCOVERY are called: "The Opportunities Set" Leena Rohela / MBA / Semester II 31.
  32. 32. Business Environment Portfolio Management  The "INDIFFERENCE CURVE" or the "UTILITY CURVE"  The OPTIMAL SOLUTION (=maximum consumption in both years).  The limitations of the CURVES: a. More than one investment alternative; b. Future streams of income are not certain; c. No investments is riskless; d. Risk=uncertainty; e. Frequency Functions.  CASE B CASE A INVESTOR A has secured income of $20,000 p.a. for the next 2 years. One investment alternative: a savings account yielding 3% p.a. (in real terms = above inflation or inflation adjusted). One borrowing alternative: unlimited money at 3% interest rate (in real terms = above inflation or inflation adjusted). Mr. Spender Will spend $20,000 in year 1 and $20,000 in year 2 and save $ 0 Mr. Spendthrift Will save $20,000 in year 1 (=give up his liquidity) and spend this money plus 3% interest $600 plus $20,000 in year 2 (=$40,600) Mr. Big Problem Leena Rohela / MBA / Semester II 32.
  33. 33. Business Environment Portfolio Management Will spend $20,000 in year 1 plus lend money against his income in year 2.He will be able to lend from the banks a maximum of: $19,417 (+3% = $20,000) HIDDEN ASSUMPTIONS IN MR. BIG Problem’s CASE: 1. That he will live on long enough to pay back his debts. 2. That his income of $20,000 in the second year is secure. 3. That this is a stable, certain economy and, therefore, interest rates will remain at the same level. THE CONCEPT OF NET PRESENT VALUE Rests on the above three assumptions (Keynes' theorem about the long run). $19,417 is the NPV of $20,000 in one year with 3%. OUR FIRST DISCOVERY: THE CONSUMPTION IN THE SECOND YEAR = THE INCOME IN THE SECOND YEAR + {Money Saved in the First Year X (1 + the interest rate)} CASE B  The concept of scenarios (Delphi) and probabilities  The Mean Value Of An Asset's Yield = Sum {Yields In Different Scenarios X Probabilities Of The Scenarios}  The properties of the Mean Value:  The mean of the multiplications of a Constant in the yields equals the multiplication of the Constant in the Mean Value of the yields. Leena Rohela / MBA / Semester II 33.
  34. 34. Business Environment Portfolio Management  The Mean of the yields on two types of assets = The Sum of the Means of each asset calculated separately  Bi-faceted securities: the example of a convertible bond.  VARIANCE and STANDARD DEVIATION as measures of the difference between mathematics and reality. They are the measures of the frustration of our expectations. THE RULE OF PREFERENCE: We will prefer a security with the highest Mean Value plus the lowest Standard Deviation.  The PRINCIPLE OF DIVERSIFICATION of the investment portfolio: The Variance of combined assets may be less than the variance of each asset separately.  THE FOUR PILLARS OF DIVERSIFICATION: a. The yield provided by an investment in a portfolio of assets will be closer to the Mean Yield than an investment in a single asset. b. When the yields are independent - most yields will be concentrated around the Mean. c. When all yields react similarly - the portfolio's variance will equal the variance of its underlying assets. d. If the yields are dependent - the portfolio's variance will be equal to or less than the lowest variance of one of the underlying assets.  Calculating the Average Yield of an Investment Portfolio.  Short - cutting the way to the Variance: PORTFOLIO COVARIANCE - the influence of events on the yields of underlying assets.  Simplifying the Covariance - the Correlation Coefficient.  Calculating the Variance of multi-asset investment portfolios. Leena Rohela / MBA / Semester II 34.
  35. 35. Business Environment Portfolio Management Leena Rohela / MBA / Semester II 35. Sr.no. State of investor Description Property Utility function 1. Diminishing avoidance of absolute risk Invests more in risky assets as his capital grows Derivative of avoidance of absolute risk < Æ Natural logarithm (Ln) of capital 2. Constant Avoidance of absolute risk Doesn't change his investment in risky assets as capital grows Derivative = Æ (-1) (e) raised to the power of a constant multiplied by the capital 3. Increasing Avoidance of absolute risk Invests less in risky assets as his capital grows Derivative > Æ (Capital) less (Constant) (Capital squared) 4. Diminishing Avoidance of relative risk Percentage invested in risky assets grows with capital growth Derivative < Æ (-1) (e) squared multiplied by the square root of the capital 5. Constant Avoidance of relative risk Percentage invested in risky assets unchanged as capital grows Derivative < Æ Natural logarithm (Ln) of capital 6. Increasing avoidance of relative risk Percentage invested in risky assets decreases with capital growth Derivative < Æ Capital - (Number) (Capital squared
  36. 36. Business Environment Portfolio Management THE EFFICIENT MARKET  Efficient Market: The price of the share reflects all available information.  The Lenient Test: Are the previous prices of a share reflected in its present price?  The Quasi - Rigorous Test: Is all the publicly available information fully reflected in the current price of a share?  The Rigorous Test: Is all the (publicly and privately) available information fully reflected in the current price of a share?  A positive answer would prevent situations of excess yields.  The main question: how can an investor increase his yield (beyond the average market yield) in a market where all the information is reflected in the price?  The Lenient version: It takes time for information to be reflected in prices. Excess yield could have been produced in this time - had it not been so short. The time needed to extract new information from prices = the time needed for the information to be reflected. The Lenient Test: will acting after the price has changed - provide excess yield.  The Quasi - Rigorous version: A new price (slightly deviates from equilibrium) is established by buyers and sellers when they learn the new information. The QR Test: will acting immediately on news provide excess yield? Leena Rohela / MBA / Semester II 36.
  37. 37. Business Environment Portfolio Management Answer: No. On average, the investor will buy at equilibrium convergent price.  The Rigorous version: Investors cannot establish the "paper" value of a firm following new information. Different investors will form different evaluations and will act in unpredictable ways. This is "The Market Mechanism". If a right evaluation was possible - everyone would try to sell or buy at the same time. The Rigorous Test: Is it at all possible to derive excess yield from information? Is there anyone who received excess yields?  New technology for the dissemination of information, professional analysis and portfolio management and strict reporting requirements and law enforcement - support the Rigorous version.  The Lenient Version: Analyzing past performance (=prices) is worthless. The QR Version: Publicly available information is worthless. The Rigorous version: No analysis or portfolio management is worth anything.  The Fair Play Theorem: Since an investor cannot predict the equilibrium, he cannot use information to evaluate the divergence of (estimated) future yields from the equilibrium. His future yields will always be consistent with the risk of the share.  Insider - Trading and Arbitrageurs.  Price predictive models assume: (a) The yield is positive and (b) High yield is associated with high risk.  Assumption (a) is not consistent with the Lenient Version. Leena Rohela / MBA / Semester II 37.
  38. 38. Business Environment Portfolio Management  Random Walk Theory (RWT): a. Current share prices are not dependent on yesterday's or tomorrow's prices. b. Share prices are equally distributed over time.  The Monte Carlo Fallacy and the Stock Exchange (no connection between colour and number).  The Fair Play Theorem does not require an equal distribution of share prices over time and allows for the possibility of predicting future prices (e.g., a company deposits money in a bank intended to cover an increase in its annual dividends).  If RWT is right (prices cannot be predicted) - the Lenient Version is right (excess yields are impossible). But if the Lenient Version is right - it does not mean that RWT is necessarily so.  The Rorschach tendency to impose patterns (cycles, channels) on totally random graphic images. The Elton - Gruber experiments with random numbers and newly - added random numbers. No difference between graphs of random numbers - and graphs of share prices.  Internal contradiction between assumption of "efficient market" and the ability to predict share prices, or price trends.  The Linear Model P = Price of share; C = Counter; ED P = Expected difference (change) in price DP = Previous change in price; R = Random number Leena Rohela / MBA / Semester II 38.
  39. 39. Business Environment Portfolio Management Pa - Pa-1 = ( ED P + D P/ ED P ) · ( Pa-1-c - Pa-2-c + R ) Using a correlation coefficient.  The Logarithmic Model ( log CPn ) / ( log CPn-1 ) = Cumulative yield CP = Closing Price Sometimes instead of CP, we use: D P / (div/P) D P = Price change div = dividend  These two models provide identical results - and they explain less than 2% of the change in share prices.  To eliminate the influence of very big or small numbers - some analyse only the + and - signs of the price changes Fama and Macbeth proved the statistical character of sign clusters.  Others say that proximate share prices are not connected - but share prices are sinusoidally connected over time. Research shows faint traces of seasonality.  Research shows that past and future prices of shares are connected with transaction costs. The higher the costs - the higher the (artificial) correlation (intended to, at least, cover the transaction costs).  The Filter (Technical Analysis) Model Sophisticated investors will always push prices to the point of equilibrium. Shares will oscillate within boundaries. If they break them, they are on the way to a new equilibrium. It is a question of timing.  Is it better to use the Filter Model or to hold onto a share or onto cash? Research shows: in market slumps, continuous holders were worse off than Leena Rohela / MBA / Semester II 39.
  40. 40. Business Environment Portfolio Management Filter users and were identical with random players. This was proved by using a mirror filter.  The filter Model provides an excess yield identical to transaction costs. Fama - Blum: the best filter was 0, 5%. For the purchase side -1%, 1, 5%. Higher filters were better than constant holding ("Buy and Hold Strategy") only in countries with higher costs and taxes.  Relative Strength Model ( CP ) / ( AP ) = RS CP = Current price AP = Average in X previous weeks a. Divide investment equally among highest RS shares. b. Sell a share who’s RS fell below the RS' of X% of all shares Best performance is obtained when: "highest RS" is 5% and X% = 70%.  RS models instruct us to invest in upwardly volatile stocks - high risk.  Research: RS selected shares (=sample) exhibit yields identical to the Group of stocks it was selected from. When risk adjusted - the sample's performance was inferior (higher risk).  Short term movements are more predictable. Example: the chances for a reverse move are 2-3 times bigger than the chances for an identical one.  Brunch: in countries with capital gains tax - people will sell losing shares to materialize losses and those will become under priced. They will correct at Leena Rohela / MBA / Semester II 40.
  41. 41. Business Environment Portfolio Management the beginning of the year but the excess yield will only cover transaction costs, (The January effect).  The market reacts identically (=efficiently) to all forms of information.  Why does a technical operation (split / reverse split) influence the price of the share (supposed to reflect underlying value of company)? Split - a symptom of changes in the company. Shares go up before a split was conceived - so split is reserved for good shares (dividend is increased). There is excess yield until the split - but it is averaged out after it.  There is considerable gap (upto 2 months) between the announcement and the split. Research shows that no excess yield can be obtained in this period.  The same for M & A  The QR Version: excess yields could be made on private information. Research: the influence of Wall Street Journal against the influence of market analyses distributed to a select public. WSJ influenced the price of the stocks - but only that day.  The Rigorous Version: excess yields cannot be made on insider information. How to test this - if we do not know the information? Study the behaviour of those who have (management, big players). Research shows that they do achieve excess yields.  Do's and Don'ts Leena Rohela / MBA / Semester II 41.
  42. 42. Business Environment Portfolio Management a. Select your investments on economic grounds. Public knowledge is no advantage. b. Buy stock with a disparity and discrepancy between the situation of the firm - and the expectations and appraisal of the public (Contrarian approach vs. Consensus approach). c. Buy stocks in companies with potential for surprises. d. Take advantage of volatility before reaching a new equilibrium. e. Listen to rumours and tips, check for yourself. Profitability and Share Prices 1. The concept of a business firm - ownership, capital and labour. 2. Profit - the change in an assets value (different forms of change). 3. Financial statements: Balance Sheet, PNL, Cash Flow, Consolidated - a review. 4. The external influences on the financial statements - the cases of inflation, exchange rates, amortization / depreciation and financing expenses. 5. The correlation between share price performance and profitability of the firms. 6. Market indicators: P/E, P/BV (Book Value). 7. Predicting future profitability and growth. Bonds 1. The various types of bonds: bearer and named; 2. The various types of bonds: straight and convertible; 3. The various types of bonds (according to the identity of the issuer); Leena Rohela / MBA / Semester II 42.
  43. 43. Business Environment Portfolio Management 4. The structure of a bond: principal (face), coupon; 5. Stripping and discounting bonds; 6. (Net) Present Value; 7. Interest coupons, yields and the pricing of bonds; 8. The Point Interest Rate and methods for its calculation (discrete and continuous); 9. Calculating yields: current and to maturity; 10.Summing up: interest, yield and time; 11.Corporate bonds; 12.Taxation and bond pricing; 13.Options included in the bonds. The Financial Statements 1. The Income Statement revenues, expenses, net earning (profits) Leena Rohela / MBA / Semester II 43.
  44. 44. Business Environment Portfolio Management 2. Expenses Costs of goods sold I Operating expenses General and administrative (G & A) expenses I (including depreciation) Interest expenses Taxes 3. Operating revenues - Operating costs = Operating income 4. Operating income + Extraordinary, nonrecurring item = Earning before Interest and Taxes (EBIT) 5. EBIT - Net interest costs = Taxable income 6. Taxable income - Taxes = Net income (Bottom line) 7. The Balance Sheet Assets = Liabilities + Net worth (Stockholders' equity) 8. Current assets = Cash + Deposits + Accounts receivable + Inventory current assets + Long term assets = Total Assets Liabilities Current (short term) liabilities = Accounts payable + Accrued taxes + Debts + Long term debt and other liabilities = Total liabilities 9. Total assets - Total liabilities = Book value 10. Stockholders' equity = Par value of stock + Capital surplus + Retained surplus 11. Statement of cash flows (operations, investing, financing) 12. Accounting Vs. Economics earnings (Influenced by inventories depreciation, Seasonality and business cycles, Inflation, extraordinary items) Leena Rohela / MBA / Semester II 44.
  45. 45. Business Environment Portfolio Management 13. Abnormal stock returns are obtained where actual earnings deviate from projected earnings (SUE - Standardized unexpected earnings). 14. The job of the security analyst: To study past data, Eliminate ² "noise" and form expectations about future dividends and earning that determine the intrinsic value (and the future price) of a stock. 15. Return on equity (ROE) = Net Profits / Equity 16. Return on assets (ROA) = EBIT / Assets 17. ROE = (1-Tax rate) [ROA + (ROA - Interest rate) × Debt / Equity] 18. Increased debt will positively contribute to a firm's ROE if its ROA exceeds the interest rate on the debt (Example) 19. Debt makes a company more sensitive to business cycles and the company carries a higher financial risk. 20. The Du Pont system ROE = Net Profit/Pretax Profit × Pretax Profit/EBIT × EBIT/Sales × Sales/Assets × Assets/Equity (1) (2) (3) (4) (5) 21. Factor 3 (Operating profit margin or return on sales) is ROS 22. Factor 4 (Asset turnover) is ATO 23. Factor 3 × Factor 4 = ROA 24. Factor 1 is the Tax burden ratio Leena Rohela / MBA / Semester II 45.
  46. 46. Business Environment Portfolio Management 25. Factor 2 is the Interest burden ratio 26. Factor 5 is the Leverage ratio 27. Factor 6 = Factor 2 × Factor 5 is the Compound leverage factor 28. ROE = the burden × ROA × Compound leverage factor 29. Compare ROS and ATO only within the same industry! 30. Fixed asset turnover = Sales / Fixed assets 31. Inventory turnover ratio = Cost of goods sold / Inventory 32. Average collection period (Days receivables) = Accounts receivables / Sales 365 33. Current ratio = Current assets / Current liabilities 34. Quick ratio = (Cash + Receivables) / Current liabilities is the Acid test ratio 35. Interest coverage ratio (Times interest earned) = EBIT / Interest expense 36. P / B ratio = Market price / Book value 37. Book value is not necessarily Liquidation value 38. P / E ratio = Market price / Net earnings per share (EPS) 39. P / E is not P /E Multiple (Emerges from DDM - Discounted dividend models) 40. Current earnings may differ from Future earnings Leena Rohela / MBA / Semester II 46.
  47. 47. Business Environment Portfolio Management 41. ROE = E / B = P/B / P/E 42. Earnings yield = E / P = ROE / P/B 43. The GAAP - Generally accepted accounting principles - allows different representations of leases, inflation, pension costs, inventories and depreciation. 44. Inventory valuation: Last In First Out (LIFO) First In First Out (FIFO) 45. Economic depreciation - The amount of a firm's operating cash flow that must be re-invested in the firm to sustain its real cash flow at the current level. Accounting depreciation (accelerated, straight line) - Amount of the original acquisition cost of an asset allocated to each accounting period over an arbitrarily specified life of the asset. 46. Measured depreciation in periods of inflation is understated relative to replacement cost. 47. Inflation affects real interest expenses (deflates the statement of real income), inventories and depreciation (inflates). B O N D S 1. BOND - IOU issued by Borrower (=Issuer) to Lender Leena Rohela / MBA / Semester II 47.
  48. 48. Business Environment Portfolio Management 2. PAR VALUE (=Face Value) COUPON (=Interest payment) 3. The PRESENT VALUE (=the Opportunity Cost) 1 / (1+r) n r = interest rate n = years 4. ANNUITY CALCULATIONS and the INFLUENCE OF INTEREST RATES: n Pb = å C / (1+r)t + PAR / (1+r)n Pb = Price of the Bond t=1 C = Coupon PAR = Principal payment n = number of payments 5. BOND CONVEXITY - an increase in interest rates results in a price decline that is smaller than the price gain resulting from a decrease of equal magnitude in interest rates. YIELD CALCULATIONS 1. YIELD TO MATURITY (IRR) = YTM 2. ANNUALIZED PERCENTAGE RATE (APR) = YTM ´ Number of periods in 1 year 3. EFFECTIVE ANNUAL YIELD (EAY) TO MATURITY = [(1+r)n - 1] n = number of periods in 1 year 4. CURRENT YIELD (CY) = C / Pb 5. COUPON RATE (C) 6. BANK DISCOUNT YIELD (BDY) = PAR-Pb / PAR ´ 360 / n n = number of days to maturity Leena Rohela / MBA / Semester II 48.
  49. 49. Business Environment Portfolio Management 7. BOND EQUIVALENT YIELD (BEY) = PAR-Pb / Pb ´365 / n 8. BEY = 365 ´ BDY / 360 - (BDY ´ n) 9. BDY < BEY < EAY 10. FOR PREMIUM BOND: C > CY > YTM (Loss on Pb relative to par) TYPES OF BONDS 1. Zero coupons, stripping 2. Appreciation of Original issue discount (OID) 3. Coupon bonds, callable 4. Invoice price = Asked price + Accrued interest 5. Appreciation / Depreciation and: Market interest rates, Taxes, Risk (Adjustment) BOND SAFETY a. Coverage ratios b. Leverage ratios c. Liquidity ratios d. Profitability ratios e. Cash flow to debt ratio f. Altman's formula (Z-score) for predicting bankruptcies: Z = 3,3 times EBIT / TOTAL ASSETS + 99,9 times SALES / ASSETS + 0,6 times MARKET VALUE EQUITY / BOOK VALUE OF DEBT + 1,4 times RETAINED Leena Rohela / MBA / Semester II 49.
  50. 50. Business Environment Portfolio Management EARNINGS / TOTAL ASSETS + 1,2 times WORKING CAPITAL / TOTAL ASSETS MACRO ECONOMY 1. Macro economy - the economic environment in which all the firms operate 2. Macroeconomic Variables: GDP (Gross Domestic Product) or Industrial Production - vs. GNP Employment (unemployment, underemployment) rate(s) Factory Capacity Utilization Rate Inflation (vs. employment, growth) Interest rates (=increase in PNV factor) Budget deficit (and its influence on interest rates & private borrowing) Current account & Trade deficit (and exchange rates) "Safe Haven" attributes (and exchange rates) Exchange rates (and foreign trade and inflation) Tax rates (and investments / allocation, and consumption) Sentiment (and consumption, and investment) 3. Demand and Supply shocks 4. Fiscal and Monetary policies 5. Leading, coincident and lagging indicators 6. Business cycles: Sensitivity (elasticity) of sales Operating leverage (fixed to variable costs ratio) Financial leverage Leena Rohela / MBA / Semester II 50.
  51. 51. Business Environment Portfolio Management MANAGING BOND PORTFOLIOS 1. Return On Investment (ROI) = Interest + Capital Gains 2. Zero coupon bonds: Pb = PAR / (1+I) n 3. Bond prices change according to interest rates, time, and taxation and to expectations about default risk, callability and inflation 4. Coupon bonds = a series of zero coupon bonds 5. Duration = average maturity of a bond's cash flows = the weight or the proportion of the total value of the bond accounted for by each payment. Wt = CFt/(1+y)t / Pb Swt = 1 = bond price Macauley's formula D = S t ´ Wt (where yield curve is flat!) 6. Duration a. Summary statistic of effective average maturity. b. Tool in immunizing portfolios from interest rate risk. c. Measure of sensitivity of portfolio to changes in interest rates. 7. DP/P = - D ´ [ D (1+y) / 1+y ] = [ - D / 1+y ] ´ D (1+y) = - Dm ´ D y 8. The EIGHT duration’s rules a. Duration of zero coupon bond = its time to maturity. b. When maturity is constant, a bond's duration is higher when the coupon rate is lower. Leena Rohela / MBA / Semester II 51.
  52. 52. Business Environment Portfolio Management c. When the coupon rate is constant, a bond's duration increases with its time to maturity. Duration always increases with maturity for bonds selling at par or at a premium. With deeply discounted bonds duration decreases with maturity. d. Other factors being constant, the duration of a coupon bond is higher when the bond's YTM is lower. e. The duration of a level perpetuity = 1+y / y f. The duration of a level annuity = 1+y/y - T/(1+y)T -1 g. The duration of a coupon bond = 1+y/y - (1+y)+T(c-y) / c[(1+y)T -1]+y h. The duration of coupon bonds selling at par values = {1+y/y ´ [1 - 1/(1+y)T ]} ´ 100 9. Passive bond management - control of the risk, not of prices. - indexing (market risk) - immunization (zero risk) 10. Some are interested in protecting the current net worth - others with payments (=the future worth). 11. BANKS: mismatch between maturities of liabilities and assets. Gap Management: certificates of deposits (liability side) and adjustable rate mortgages (assets side) 12. Pension funds: the value of income generated by assets fluctuates with interest rates Leena Rohela / MBA / Semester II 52.
  53. 53. Business Environment Portfolio Management 13. Fixed income investors face two types of risks: Price risk Reinvestment (of the coupons) rate risks 14. If duration selected properly the two effects cancel out. For a horizon equal to the portfolio's duration - price and re-investment risks cancel out. 15. BUT: Duration changes with yield rebalancing 16. BUT: Duration will change because of the passage of time (it decreases less rapidly than maturity) 17. Cash flow matching -buying zeros or bonds yielding coupons equal to the future payments (dedication strategy) 18. A pension fund is a level perpetuity and its duration is according to rule (E). 19. There is no immunization against inflation (except indexation). 20. Active bond management - Increase / decrease duration if interest rate declines / increases are forecast - Identifying relative mispricing 21. The Homer - Leibowitz taxonomy: a. Substitution swap - replacing one bond with identical one. b. Intermarket spread swap - when the yield spread between two sectors of the bond market is too wide. c. Rate anticipation swap - changing duration according to the forecasted interest rates. Leena Rohela / MBA / Semester II 53.
  54. 54. Business Environment Portfolio Management d. Pure yield pickup swap - holding higher yield bond. e. Tax swap - intended to exploit tax advantages. 22. Contingent immunization (Leibowitz - Weinberger): Active management until portfolio drops to minimum future value / (1+I)T = Trigger value if portfolio drops to trigger value - immunization. 23. Horizon Analysis Select a Holding Period Predict the yield curve at the end of that period [We know the bond's time to maturity at the end of the holding period] {We can read its yield from the yield curve} determine price 24. Riding the yield curve If the yield curve is upward sloping and it is projected not to shift during the investment horizon as maturities fall (=as time passes) - the bonds will become shorter - the yields will fall - capital gains Danger: Expectations those interest rates will rise. Leena Rohela / MBA / Semester II 54.
  55. 55. Business Environment Portfolio Management INTEREST RATE SWAPS 1. Between two parties exposed to opposite types of interest rate risk. Example: SNL CORPORATION Short term - Long term Variable rate liabilities - Fixed rate liabilities Long term - Short term Fixed rate assets - Variable rate assets Risk: Rising interest rates Risk: Falling interest rates 2. The Swap SNL would make fixed rate payments to the corporation based on a notional amount Corporation will pay SNL an adjustable interest rate on the same notional amount 3. After the swap SNL CORPORATION ASSETS LIABILITIES ASSETS LIABILITIES Long term loans Short term deposits Short term assets Long term bonds (claim to) variable (obligation to) make (claim to) fixed (obligation to) make - rate cash flows fixed cash payments cash flows variable-rate payments net worth net worth William Sharpe, John Lintner, Jan Mossin Leena Rohela / MBA / Semester II 55.
  56. 56. Business Environment Portfolio Management 1. Capital Asset Pricing Model (CAPM) predicts the relationship between an asset's risk and its expected return = benchmark rate of return (investment evaluation) = expected returns of assets not yet traded 2. Assumptions [Investors are different in wealth and risk aversion} but: a. Investor's wealth is negligible compared to the total endowment; b. Investors are price - takers (prices are unaffected by their own trade); c. All investors plan for one, identical, holding period (myopic, suboptimal behaviour); d. Investments are limited to publicly traded financial assets and to risk free borrowing / lending arrangements; e. No taxes on returns, no transaction costs on trades; f. Investors are rational optimizers (mean variance - Markowitz portfolio selection model); g. All investors analyse securities the same way and share the same economic view of the world ® homogeneous expectations identical estimates of the probability distribution of the future cash flows from investments. 3. Results a. All the investors will hold the market portfolio. b. The market portfolio is the best, optimal and efficient one. A passive (holding) strategy is the best. Investors vary only in allocating the amount between risky and risk - free assets. c. The risk premium on the market portfolio will be proportional to: its risk and the investor's risk aversion Leena Rohela / MBA / Semester II 56.
  57. 57. Business Environment Portfolio Management d. The risk premium on an individual asset will be proportional to the risk premium on the market portfolio and the beta coefficient of the asset (relative to the market portfolio). Beta measures the extent to which returns on the stock and the market move together. 4. Calculating the Beta a. The graphic method The line from which the sum of standard deviations of returns is lowest. The slope of this line is the Beta. b. The mathematical method ¥¥ bi = Cov (ri, rm) / sm 2 = S (yti-yai)(ytm-yam) / S (ytm- tam)2 =1 t=1 5. Restating the assumptions a. Investors are rational b. Investors can eliminate risk by diversification - sectoral - international c. Some risks cannot be eliminated - all investments are risky d. Investors must earn excess returns for their risks (=reward) e. The reward on a specific investment depends only on the extent to which it affects the market portfolio risk (Beta) f. Diversified investors should care only about risks related to the market portfolio. Leena Rohela / MBA / Semester II 57.
  58. 58. Business Environment Portfolio Management 6. Return Beta 1/2 1 2 Investment with Beta 1/2 should earn 50% of the market's return with Beta 2 - twice the market return. 7. Recent research discovered that Beta does not work. A better measure: B / M (Book Value) / (Market Value) 8. If Beta is irrelevant - how should risks be measured? 9. NEER (New Estimator of Expected Returns): The B to M ratio captures some extra risk factor and should be used with Beta 10. Other economists: There is no risk associated with high B to M ratios. Investors mistakenly under price such stocks and so they yield excess returns. 11. FAR (Fundamental Asset Risk) - Jeremy Stein There is a distinction between: a) Boosting a firm's long term value and b) Trying to raise the share's price If investors are rational: Beta cannot be the only measure of risk ® we should stop using it Any decision boosting (A) will affect (B) ® (A) and (B) are the same? If investors are irrational Beta is right (it captures an asset's fundamental risk = its contribution to the market portfolio risk) ® we should use it, even if investors irrational if investors are making predictable mistakes - a manager must choose: If he wants (B) ® NEER (accommodating investors expectations) If he wants (A) BETA Leena Rohela / MBA / Semester II 58.
  59. 59. Business Environment Portfolio Management TECHNICAL ANALYSIS Part A  Efficient market hypothesis - share prices reflect all available information  Weak form Are past prices reflected in present prices? No price adjustment period - no chance for abnormal returns (prices reflect information in the time that it takes to decipher it from them) If we buy after the price has changed - will we have abnormal returns? Technical analysis is worthless  Semistrong form Is publicly available information fully reflected in present prices? Buying price immediately after news will converge, on average, to equilibrium Public information is worthless Strong form  Is all information - public and private - reflected in present prices? No investor can properly evaluate a firm All information is worthless Fair play - no way to use information to make abnormal returns An investor that has information will estimate the yield and compare it to the equilibrium yield. The deviation of his estimates from equilibrium cannot predict his actual yields in the future. His estimate could be > equilibrium > actual yield or vice versa. On average, his yield will be commensurate with the risk of the share. Two basic assumptions a) Yields is positive b) High / low yields indicates high / low risk If (A) is right, past prices contain no information about the future  Random walk a) Prices are independent (Monte Carlo fallacy) b) Prices are equally distributed in time  The example of the quarterly increase in dividends  The Rorschach Blots fallacy (patterns on random graphical designs) Leena Rohela / MBA / Semester II 59.
  60. 60. Business Environment Portfolio Management ® cycles (Kondratieff)  Elton - Gruber experiments with series of random numbers  Price series and random numbers yield similar graphs  The Linear model Pa - Pa-1 = (ED P +) ´ (Pa-1-c - Pa-z-c + R) P = Price of share C = Counter ED P = Expected change in Price R = Random number  The Logarithmic model = cum. Y Sometimes, instead of Pc we use D P +  Cluster analysis (Fama - Macbeth) + and - distributed randomly. No statistical significance.  Filter models - share prices will fluctuate around equilibrium because of profit taking and bargain hunting  New equilibrium is established by breaking through trading band  Timing - percentage of break through determines buy / sell signals  Filters effective in BEAR markets but equivalent to random portfolio management  Fama - Blum: best filter is the one that covers transaction costs  Relative strength models - P / P Divide investment equally between top 5% of shares with highest RS and no less than 0,7 Sell shares falling below this benchmark and divide the proceeds among others Reservations: A) High RS shares are the riskiest B) The group selected yields same as market - but with higher risk Leena Rohela / MBA / Semester II 60.
  61. 61. Business Environment Portfolio Management TECHNICAL ANALYSIS - Part B  Versus fundamental: dynamic (trend) vs. static (value)  Search for recurrent and predictable patterns  Patterns are adjustment of prices to new information  In an efficient market there is no such adjustment, all public information is already in the prices  The basic patterns: a) momentum b) breakaway c) head and shoulders ® chartists  Buy/sell signals Example: Piercing the neckline of Head and Shoulders  The Dow theory uses the Dow Jones industrial average (DJIA) as key indicator of underlying trends + DJTransportation as validator  Primary trend - several months to several years Secondary (intermediate) trend - deviations from primary trend: 1/3, 1/2, 2/3 of preceding primary trend Correction - return from secondary trend to primary trend Tertiary (minor) trend - daily fluctuations  Channel - tops and bottoms moving in the direction of primary trend  Technical analysis is a self fulfilling prophecy - but if everyone were to believe in it and to exploit it, it would self destruct. People buy close to resistance because they do not believe in it.  The Elliott Wave theory - five basic steps, a fractal principle  Moving averages - version I - true value of a stock is its average price prices converge to the true value version II - crossing the price line with the moving Leena Rohela / MBA / Semester II 61.
  62. 62. Business Environment Portfolio Management average line predicts future prices Relative strength - compares performance of a stock to its sector or to the performance of the whole market  Resistance / support levels - psychological boundaries to price movements assumes market price memory  Volume analysis - comparing the volume of trading to price movements high volume in upturns, low volume in down movements - trend reversal  Trin (trading index) = Trin > 1 Bearish sign  BEAR / Bull markets - down/up markets disturbed by up/down movements  Trendline - price moves up to 5% of average  Square - horizontal transition period separating price trends (reversal patterns)  Accumulation pattern - reversal pattern between BEAR and BULL markets  Distribution pattern - reversal pattern between BULL and BEAR markets  Consolidation pattern - if underlying trends continues  Arithmetic versus logarithmic graphs  Sea saw - non breakthrough penetration of resistance / support levels  Head and shoulder formation (and reverse formation): Small rise (decline), followed by big rise (decline), followed by small rise (decline). First shoulder and head-peak (trough) of BULL (BEAR) market. Volume very high in 1st shoulder and head and very low in 2nd shoulder.  Neckline - connects the bottoms of two shoulders. Signals change in market direction.  Double (Multiple) tops and bottoms Two peaks separated by trough = double tops Volume lower in second peak, high in penetration The reverse = double bottoms Leena Rohela / MBA / Semester II 62.
  63. 63. Business Environment Portfolio Management  Expanding configurations Price fluctuations so that price peaks and troughs can be connected using two divergent lines. Shoulders and head (last). Sometimes, one of the lines is straight: UPPER (lower down) or - accumulation, volume in penetration LOWER (upper up) 5% penetration signals reversal  Conservative upper expanding configuration Three tops, each peaking Separated by two troughs, each lower than the other Signals peaking of market 5% move below sloping trendline connecting two troughs or below second through signals reversal  Triangles - consolidation / reversal patterns  Equilateral and isosceles triangle (COIL - the opposite of expansion configuration) Two (or more) up moves + reactions Each top lower than previous - each bottom higher than previous connecting lines converge Prices and volume strongly react on breakthrough  Triangles are accurate when penetration occurs Between 1/2 - 3/4 of the distance between the most congested peak and the highest peak.  Right angled triangle Private case of isosceles triangle. Often turn to squares.  Trendlines Connect rising bottoms or declining tops (in Bull market) Horizontal Trendlines  Necklines of H&S configurations And the upper or lower boundaries of a square are trendlines.  Upward trendline is support Declining trendline is resistance  Ratio of penetrations to number of times that the trendline was only touched without being penetrated Also: the time length of a trendline the steepness (gradient, slope) Leena Rohela / MBA / Semester II 63.
  64. 64. Business Environment Portfolio Management  The penetration of a steep trendline is less meaningful and the trend will prevail.  Corrective fan At the beginning of Bull market - first up move steep, price advance unsustainable. This is a reaction to previous down moves and trendline violated. New trendline constructed from bottom of violation (decline) rises less quickly, violated. A decline leads to third trendline. This is the end of the Bull market (The reverse is true for Bear market.)  Line of return - parallel to up market trendline, connects rising tops (in uptrends) or declining bottoms (in downtrends).  Trend channel - the area between trendlines and lines of return.  Breach of line of return signals (temporary) reversal in basic trend.  Simple moving average of N days where last datum replaces first datum changes direction after peak / trough.  Price < MA ® Decline Price > MA ® Upturn  MA at times support in Bear market resistance in Bull market  Any break through MA signals change of trend. This is especially true if MA was straight or changed direction before. If broken trough while continuing the trend - a warning. We can be sure only when MA straightens or changes.  MA of 10-13 weeks secondary trends MA of 40 weeks primary trends Best combination: 10+30 weeks  Interpretation 30w down, 10w < 30w downtrend 30w up, 10w > 30w uptrend  10w up, 30w down (in Bear market) 10w down, 30w up (in Bull market) No significance  MAs very misleading when market stabilizes and very late.  Weighted MA (1st version) Emphasis placed on 7w in 13w MA (wrong - delays warnings) Emphasis placed on last weeks in 13w Leena Rohela / MBA / Semester II 64.
  65. 65. Business Environment Portfolio Management  Weighted MA (2nd version) Multiplication of each datum by its serial number.  Weighted MA (3rd version) Adding a few data more than once.  Weighted MAs are autonomous indicators - without being crossed with other MAs.  Exponential MA - algorithm 1. Simple 20w MA 2. Difference between 21st datum and MA multiplied by exponent (2/N) = result 1 3. Result 1 added to MA 4. If difference between datum and MA negative - subtract, not add  Envelopes Symmetrical lines parallel to MA lines (which are the centre of trend) give a sense of the trend and allow for fatigue of market movement.  Momentum Division of current prices by prices a given time ago Momentum is straight when prices are stable When momentum > reference and going up market up (Bull) When momentum > reference and going down Bull market stabilizing When momentum < reference and going down market down (Bear) When momentum < reference and going up Bear market stabilizing  Oscillators measure the market internal strengths:  Market width momentum Measured with advance / decline line of market (=the difference between rising / falling shares) When separates from index - imminent reversal momentum = no. of rising shares / no. of declining shares  Index to trend momentum Index divided by MA of index  Fast lines of resistance (Edson Gould) The supports / resistances will be found in 1/3 - 2/3 of previous price movement. Breakthrough means new tops / bottoms. Leena Rohela / MBA / Semester II 65.
  66. 66. Business Environment Portfolio Management  Relative strength Does not indicate direction - only strength of movement. More Technical Analysis: 1. Williams %R = 100 x r = time frame 2. The Williams trading signals: a. Divergence:  Bearish - WM% R rises above upper reference line Falls Cannot rise above line during next rally  Bullish - WM% R falls below lower reference line Rallies Cannot decline below line during next slide b. Failure swing: When WM%R fails to rise above upper reference line during rally or Fall below lower reference line during decline 3. Stochastic: A fast line (%K) + slow line (%D) Steps a) Calculate raw stochastic (%K) = x 100 n = number of time units (normally 5) b) %D = x 100 (smoothing) 4. Fast stochastic: %K + %D on same chart (%K similar to WM%R) 5. Slow stochastic: Leena Rohela / MBA / Semester II 66.
  67. 67. Business Environment Portfolio Management %D smoothed using same method 6. Stochastic trading signals: a. Divergence  Bullish Prices fall to new low Stochastic traces a higher bottom than during previous decline  Bearish Prices rally to new high Stochastic traces a lower top than during previous rally b. Overbought / Oversold  When stochastic rallies above upper reference line - market O/B  When stochastic falls below lower reference line - market O/S  Line direction When both lines are in same direction - confirmation of trend 7. Four ways to measure volume  No, of units of securities traded  No, of trades  Tick volume  Money volume 8. OBV Indicator (on-balance volume) Running total of volume with +/- signs according to price changes 9. Combined with: a) The Net Field trend Indicator (OBV calculated for each stock in the index and then rated +1, -1, 0) b) Climax Indicator The sum of the Net Field Trend Indicators 10. Accumulation / Distribution Indicator A/D = x V 11. Volume accumulator Uses P instead of 0. Leena Rohela / MBA / Semester II 67.
  68. 68. Business Environment Portfolio Management 12. Open Interest Number of contract held by buyers or owed by short sellers in a given market on a given day. 13. Herrich Payoff Index (HPI) HPI = Ky + (K' - Ky) K = [(P - Py) x C x V] x [1 ± {(½ I - Iy½ x 2 / G} G= today's or yesterday's I (=open interest, whichever is less) +/- determined: if P > Py (+), if P < Py (-) Journals Getting start with portfolio management I'd like to take up a question that is frequently asked by clients and potential clients regarding project portfolio management techniques: How do you begin introducing this discipline into an organization? This question most frequently occurs during, or immediately after, an overview briefing which describes the contents, context, and basic ideas and concepts of portfolio management as a discipline. It's a fair question, and there's a lot more to the answer than I can usually provide in a short briefing session. However, there are a few key points I would like to make. As in the adoption of any new capability that addresses organizational structures, policies, and processes, the climate and culture of the organization is a major factor in determining how difficult or easy the change will be. The introduction of portfolio management practices must not only take into consideration process at the practitioner and project manager levels of the organization; it must be driven by the strategic direction which is set by the senior management. If they're committed to the use of portfolio management, senior management will see the initiatives undertaken by the organization as investments with various rates Leena Rohela / MBA / Semester II 68.
  69. 69. Business Environment Portfolio Management of return, benefits and needed outcomes, and associated risks. And, this is why the whole concept of the "portfolio"(as in "investment portfolio") is applied to this area of business and IT governance. As I noted in my October 2005 article in The Rational Edge, Morgan Stanley's Dictionary of Financial Terms offers the following explanation of the term "portfolio": If you own more than one security, you have an investment portfolio. You build the portfolio by buying additional stocks, bonds, mutual funds, or other investments. Your goal is to increase the portfolio's value by selecting investments that you believe will go up in price. According to modern portfolio theory, you can reduce your investment risk by creating a diversified portfolio that includes enough different types, or classes, of securities so that at least some of them may produce strong returns in any economic climate.1 In a non-financial business context, projects and initiatives are the instruments of investment. An Initiative, in the simplest sense, is a body of work with: • A specific (and limited) collection of needed results or work products. • A group of people who are responsible for executing the initiative and use resources, such as funding. • A defined beginning and end. Managers can group together a number of initiatives into a portfolio that supports a business segment, product, or product line (or some other segmentation scheme). These efforts are goal-driven; that is, they support major goals and/or components of the enterprise's business strategy. Managers must continually choose among competing initiatives (i.e., manage the organization's investments), selecting those that best support and enable diverse Leena Rohela / MBA / Semester II 69.
  70. 70. Business Environment Portfolio Management business goals (i.e., they diversify investment risk). They must also manage their investments by providing continuing oversight and decision-making about which initiatives to undertake, which to continue, and which to reject or discontinue. Understanding the type of effort involved So, here is my first key point: You must understand what type of work effort the introduction and implementation of portfolio management practices represents in order to identify an effective approach to its execution. You must also identify which capabilities and experience within your organization (or outside it) you will require enabling that execution. The type and context of the effort must be understood in order to approach, plan, and execute the implementation of portfolio management practices. For example, we would approach a piece of work identified as "research and development" differently from a piece of work identified as "building construction." Even better, if we understand the type of work, and its context; we may be able to identify organizational and individual capabilities and experience, and we may identify which existing methods, practices, and approaches exist now, and be able to adapt and reuse them. Here is an example:- In a conversation with an IT executive, a financial executive said that he wanted to implement and automate certain types of financial management practices. The IT executive thinks: "Ah ha, sounds like he is looking for a software package!" So he asks his staff to use existing organizational practices to research and identify the leading software packages in the area of financial management. As candidates, they identify such software packages as Oracle Financials and SAP Analytics.2 If the need of the financial executive is pursued as an organizational initiative, a project or program manager in the IT area will, as a beginning point for planning, Leena Rohela / MBA / Semester II 70.
  71. 71. Business Environment Portfolio Management reference a portion of the organizational IT practices that deals with "Commercial- Of-The-Shelf (COTS) Selection, Planning and Implementation." Determining the type of work, or the context for the work, has a direct correlation to the selection of an approach to the completion of the work, and the identification and the use of capabilities, experience, and well- understood and documented methods and practices. In this example, the "type of work" identified is that which deals with the selection and implementation of COTS (packaged) software. The type or context for the work for getting started with portfolio management and its practices has multiple elements. We will examine three elements. Capability Assessment Portfolio Management, as a discipline, does not exist in isolation. Rather, it is effectively exercised based upon a solid foundation of existing organizational (and individual) capabilities. These capabilities support, enable, and sustain certain aspects of the work of portfolio management. For example, much in the same way that excellent hand-eye coordination is a sustaining capability for a baseball or cricket player, the existence of a solid project management capability is a sustaining capability for portfolio management. Let us define capability assessment as follows: Capability assessment is the activity of surveying, analyzing, and measuring the ability of organizations and individuals to perform and be successful at some discipline. In order to be successful with portfolio management, there are a number of enabling capabilities which an organization and its staff must possess. One of the early tasks on the road to the successful use of portfolio management and its Leena Rohela / MBA / Semester II 71.
  72. 72. Business Environment Portfolio Management practices is to survey the current state of these enabling capabilities and to measure their maturity across the organization. The survey results, when analyzed, will indicate which enabling items provide a solid foundation and where some improvement work is required. For the areas in which improvement is needed, it is possible to define, plan, and execute multiple efforts over time to improve various capabilities, and to achieve a maturity and practice level which will contribute to enabling and sustaining one or more aspects of portfolio management and its practices. It is important to understand that there are a variety of models and practices which exist and which can be used to define and to plan a form of capability assessment appropriate to portfolio management and its practices. Process Definition And Implementation Portfolio management is a discipline. Its exercise requires the definition, communication, and use of agreed policies, principles, and practices shared by all in the organization. Taken all together, the combination of these policies, principles, and practices form the basis of an organizational process. Here is an illustration: Consider a group of investors that decides to go into the automobile manufacturing business. The approach they use is to hire individuals with previous experience in various aspects of automobile manufacturing. They lease manufacturing buildings, and they order a variety of machine tools. They appoint a chief executive officer (CEO). On a specific day, all of the staff is directed to report to work. The leader of the investment group, and the CEO, deliver short remarks to inspire the workers for the future. Finally, they are all directed to "get to work," and they are wished "good luck." Leena Rohela / MBA / Semester II 72.
  73. 73. Business Environment Portfolio Management In this rather simple (and not very realistic example) one element (among many!) is missing. There is no agreed and ordered set of work steps, allocation of skills, definition of interim results, or metrics for production to guide the work of the staff. That is, there is no organizational process. Portfolio management, as a discipline, must be exercised by means of a number of integrated and interacting work processes. These processes must be defined, reviewed, validated (by means of use) and continuously refined and adjusted. Their development and introduction (process definition and implementation) and use must be accompanied by the work of communication, consensus building, risk management, assignment of responsibilities, and other effort to ensure that they are effectively instantiated, and also "fit" into the overall ways-of-working of the organization. Again, there are a variety of models, and methods and practices which deal with the definition (or "tailoring" of existing) of processes, and the implementation of processes within an organization. Organizational Change Management Organizations are complex organisms which evolve continuously. They contain individuals and organizational entities with multiple (and often competing) goals, a variety of functions and initiatives which are carried on, and a need for successes in the form of results and deliveries which create the revenue to ensure the continuance of the organization. Portfolio management is a discipline which requires the definition and implementation of specific organizational entities and individual roles in order to establish who carries on what work effort. Clearly the existing organization -- as a complex organism -- will be impacted by the need to "fit" a new discipline and its Leena Rohela / MBA / Semester II 73.
  74. 74. Business Environment Portfolio Management organizational entities, individual roles, and also its goals, and functions, into the existing order. The type of work effort which is concerned with the capabilities, policies, and practices that, ideally, are successful in the introduction of change into an existing organization is typically identified as organizational change management. The disciplines associated with organizational change management provide an approach, a lifecycle, and well-understood work products and outcomes to minimize the impact and the risk of the insertion of change into an existing order. Understanding The Current State: Capabilities And Readiness My second key point is that management must assess and understand existing capabilities within the organization that will be required to enable and sustain the exercise of portfolio management practices. Management must also determine if the organization is ready to move ahead with portfolio management practices introduction and implementation. Management needs to identify an organizational starting point that will provide needed input to the development of an implementation strategy for portfolio management practices. As anyone who has done any cross-country hiking will tell you, there are two data points which must be in-hand before a course can be plotted: the starting point and the ending point. A compass and a good map will do you no good unless you know where you're starting and ending. This is not an over-simplification. Many times in various kinds of projects and programs, there is a great deal of time and work devoted to identifying the ending Leena Rohela / MBA / Semester II 74.

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