Security analysis and portfolio management

1. Security analysis and portfolio management
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₹INVESTMENT

3. Return
Tax minimization
Marketability/Liquidity
To beat inflation
Wealth Maximization
OBJECTIVES

4. ALTERNATIVE INVESTMENT

5. Systematic
Risk
Unsystematic
Risk
RISK IN INVESTMENT

6. It is a non-diversifiable risk. Which is beyond the control of a specific
company or Individual.
SYSTEMATIC RISK (ß)
Market Risk
Interest Rate Risk
Purchasing Power Risk (or
Inflation Risk)
Exchange Rate Risk

7. Market risk is caused by the herd mentality of investors, i.e. the
tendency of investors to follow the direction of the market. Hence,
market risk is the tendency of security prices to move together. If the
market is declining, then even the share prices of good performing
companies fall. Market risk constitutes almost two-thirds of total
systematic risk. Therefore, sometimes the systematic risk is also
referred to as market risk. Market price changes are the most
prominent source of risk in securities.
MARKET RISK

8. Interest rate risk arises due to changes in market interest rates. In
the stock market, this primarily affects fixed income securities
because bond prices are inversely related to the market interest rate.
In fact, interest rate risks include two opposite components: Price
Risk and Reinvestment Risk. Both these risks work in opposite
directions. Price risk is associated with changes in the price of a
security due to changes in interest rate. Reinvestment risk is
associated with reinvesting interest/ dividend income. If price risk is
negative (i.e. fall in price), reinvestment risk would be positive (i.e.
increase in earnings on reinvested money). Interest rate changes are
the main source of risk for fixed income securities such as bonds and
debentures.
INTEREST RATE RISK

9. Purchasing power risk arises due to inflation. Inflation is the
persistent and sustained increase in the general price level. Inflation
erodes the purchasing power of money, i.e., the same amount of
money can buy fewer goods and services due to an increase in
prices. Therefore, if an investor’s income does not increase in times
of rising inflation, then the investor is actually getting lower income in
real terms. Fixed Income securities are subject to a high level of
purchasing power risk because income from such securities is fixed
in nominal terms. It is often said that equity shares are good hedges
against inflation and hence subject to lower purchasing power risk.
PURCHASING POWER RISK (OR
INFLATION RISK)

10. In a globalized economy, most of the companies have exposure to
foreign currency. Exchange rate risk is the uncertainty associated
with changes in the value of foreign currencies. Therefore, this type
of risk affects only the securities of companies with foreign exchange
transactions or exposures such as export companies, MNCs, or
companies that use imported raw material or products.
EXCHANGE RATE RISK

11. • Covariance measures how two stocks move together. A positive covariance
means the stocks tend to move together when their prices go up or down. A
negative covariance means the stocks move opposite of each other.
• Variance, on the other hand, refers to how far a stock moves relative to its
mean. For example, variance is used in measuring the volatility of an
individual stock's price over time. Covariance is used to measure the
correlation in price moves of two different stocks.
Covariance
ß =-------------------------
Variance
HOW TO CALCULATE BETA

12. Let's assume the investor wants to calculate the beta of Tesla
Motors Inc. (TSLA) in comparison to the SPDR S&P 500 ETF Trust
(SPY). Based on data over the past five years, TSLA and SPY have
a covariance of 0.032, and the variance of SPY is 0.015.
Beta of TSLA =0.032 ÷ 0.015 = 2.13
Therefore, TSLA is theoretically 113% more volatile than the SPDR
S&P 500 ETF Trust.
LET’S SEE THE EXAMPLE

13. Say we have the data points 5, 7, 3, and 7, which total 22. You would
then divide 22 by the number of data points, in this case, four—resulting
in a mean of 5.5. This leads to the following determinations: x̄ = 5.5 and
N = 4.
The variance is determined by subtracting the value of the mean from
each data point, resulting in -0.5, 1.5, -2.5 and 1.5. Each of those values
is then squared, resulting in 0.25, 2.25, 6.25 and 2.25. The square
values are then added together, resulting in a total of 11, which is then
divided by the value of N minus 1, which is 3, resulting in a variance
approximately of 3.67.
𝑛
𝑖 = 1
(xi- x̄ )2
Variance = ---------------------------------------------------------------------------
N – 1
xi = Value of each data point
x̄ = Mean
N = Number of data points
VARIANCE

14. Covariance evaluates how the mean values of two variables move
together. If stock A's return moves higher whenever stock B's return
moves higher and the same relationship is found when each stock's
return decreases, then these stocks are said to have a positive
covariance. In finance, covariance are calculated to
help diversify security holdings.
Cov(x,y) = SUM [(xi - xm) * (yi - ym)] / (n - 1)
COVARIANCE

15. Q1: x = 2, y = 10
Q2: x = 3, y = 14
Q3: x = 2.7, y = 12
Q4: x = 3.2, y = 15
Q5: x = 4.1, y = 20
The average x value equals 3, and the average y value equals
14.2. To calculate the covariance, the sum of the products of the
xi values minus the average x value, multiplied by the yi values minus
the average y values would be divided by (n-1), as follows:
Cov(x,y) = ((2 - 3) x (10 - 14.2) + (3 - 3) x (14 - 14.2) + ... (4.1 - 3) x
(20 - 14.2)) / 4 = (4.2 + 0 + 0.66 + 0.16 + 6.38) / 4 = 2.85
EXAMPLE

16. The Markowitz efficient set is a portfolio with returns that are
maximized for a given level of risk based on mean-
variance portfolio construction.
Markowitz efficient set is represented on a graph with returns on the
Y-axis and risk (standard deviation) on the X-axis. The efficient set
lies along the line (frontier line) where increasing risk is positively
correlated with increasing returns, or another way of saying this is
"higher risk, higher returns," but the key is to construct a set of
portfolios to yield the highest returns at a given level of risk.
MARKOWITZ EFFICIENT
FUNCTION.

17. GRAPHICAL VIEW

18. The chart above shows a hyperbola showing all the outcomes for
various portfolio combinations of risky assets, where Standard
Deviation is plotted on the X-axis and Return is plotted on the Y-axis.
The Straight Line (Capital Allocation Line) represents a portfolio of all
risky assets and the risk-free asset, which is usually a triple-A rated
government bond.
Tangency Portfolio is the point where the portfolio of only risky assets
meets the combination of risky and risk-free assets. This portfolio
maximizes return for the given level of risk.
Portfolio along the lower part of the hyperbole will have lower return
and eventually higher risk. Portfolios to the right will have higher
returns but also higher risk.
EXPLANATION